Foreign Currency Transaction Bookkeeping

A foreign currency transaction is necessary when a business undertakes an accounting transaction in a currency other than its own reporting currency. For example the business might export to customers overseas giving rise to revenue and accounts receivable in a foreign currency or it might purchase imported goods from suppliers overseas giving rise to expenses and accounts payable in a foreign currency.

Exchange Rates

When a foreign currency transaction takes place an exchange rate is used to translate one currency into another currency.

The exchange rate simply expresses the value of one currency in terms of the other. For example if the exchange rate of US Dollars (USD) to British Pounds Sterling (GBP) is quoted as 0.77 it means that USD 1 is worth GBP 0.77. If a business wanted to convert say USD 1,200 into GBP the calculation would be as follows.

```Exchange rate USD to GBP = 0.77
USD = 1200
GBP = 0.77 x USD
GBP = 0.77 x 1,200 = 924
```

This shows that at the exchange rate of 0.77 USD 1,200 is worth GBP 924.

Of course exchange rates vary over time, at a later date if the exchange rate changes such that USD 1 is worth GBP 0.75, the calculation would be as follows.

```Exchange rate USD to GBP = 0.75
USD = 1200
GBP = 0.75 x USD
GBP = 0.75 x 1,200 = 900
```

Due to the change in exchange rates USD 1,200 is now only worth GBP 900, a fall of GBP 24.

It is clear then that the change in exchange rates overtime can result in a change in the value of a foreign currency transaction and this needs to be reflected in the bookkeeping records of the business.

There are three main stages at which to consider the effect of exchange rates.

1. Initial transaction date: The date on which the purchase or sale takes place.
2. Accounting period end date: The date on which the accounting period ends.
3. Settlement date: The date on which payment or receipt takes place.

Foreign Currency Transaction Example – Import Purchase

Initial Transaction Date

Suppose a business uses US Dollars as its functional reporting currency and purchases equipment imported from a supplier whose prices are quoted in British Pounds Sterling. The purchase price of the equipment is GBP 7,000.

Since the business operates in USD the first step is to find the exchange rate to convert the foreign currency transaction from GBP to USD. If the exchange rate GBP to USD at the date of purchase is say 1.30, then the calculation to convert the amount is as follows.

```Exchange rate GBP to USD = 1.30
GBP = 7,000
USD = 1.30 x GBP
USD = 1.30 x 700 = 9,100
```

The cost of the equipment is therefore USD 9,100.

Foreign Currency Transaction Journal Entry #1

To reflect to purchase of the equipment the following transaction is now posted in the reporting currency (USD) of the business.

Foreign currency transaction – Initial purchase
Account Debit Credit
Equipment 9,100
Accounts payable 9,100
Total 9,100 9,100

At the date of purchase the business records the equipment costing USD 9,100 and an amount owed to the supplier of USD 9,100

Year End Date

Assuming the liability to the overseas supplier has not been paid at the year end the business must account for any changes in the value of that liability due to exchange rate changes between the initial transaction date and the year end date.

The business owes the supplier GBP 7,000 and has reflected this foreign currency transaction in its accounting records as USD 9,100 using the exchange rate at the time of the initial transaction of 1.30. Suppose at the year end the exchange rate to convert GBP to USD is 1.25, the value of the liability to the supplier is now calculated as follows.

```Exchange rate GBP to USD = 1.25
GBP = 7,000
USD = 1.25 x GBP
USD = 1.25 x 7,000 = 8,750
```

At the year end exchange rate the business owes a smaller amount of 8,750 compared to the amount of 9,100 currently reflected in its accounting records. The difference of USD 350 is referred to as an unrealized exchange rate gain as the amount is yet to be settled.

Foreign Currency Transaction Journal Entry #2

To adjust for the exchange rate gain at the year end the following foreign currency transaction is recorded.

Foreign currency transaction – Year end date
Account Debit Credit
Accounts payable 350
Foreign currency transaction gain 350
Total 350 350

At the year end the balance on the accounts payable account with the supplier is now USD 9,100 – 350 = USD 8,750. The exchange rate gain is recorded in the income statement of the business under the heading of foreign currency transaction gain.

Settlement Date

Subsequent to the year end the business pays the overseas supplier. The amount owed is GBP 7,000 but since the business reports in USD it must now convert the amount using the exchange rate at the settlement date.

Suppose at the settlement date the exchange rate to convert GBP to USD is now 1.22, the value of the liability to the supplier is calculated as follows.

```Exchange rate GBP to USD = 1.22
GBP = 7,000
USD = 1.22 x GBP
USD = 1.22 x 7,000 = 8,540
```

Due to the change in exchange rate between the year end date (1.25) and the settlement date (1.22) the business only needs to pay USD 8,540 to settle the liability of GBP 7,000. The liability is currently reflected in its accounting records at USD 8,750, and the difference of USD 210 is a further foreign currency transaction gain.

Foreign Currency Transaction Journal Entry #3

Foreign currency transaction – Settlement
Account Debit Credit
Accounts payable 8,750
Foreign currency transaction gain 210
Cash 8,540
Total 8,750 8,750

The balance on the overseas supplier account of 8,750 has now been cleared by a payment of USD 8,540 (GBP 7,000) and the foreign currency transaction gain of 210.

It should be noted that the business purchased equipment for GBP 7,000 and paid GBP 7,000. The foreign currency transactions arise because the reporting currency of the business is USD and the exchange rate varies between the initial purchase date (1.30), the year end date (1.25) and the settlement date (1.22). The net effect is the business recorded equipment of USD 9,100 and paid USD 8,540, recording a total foreign currency transaction realized exchange gain of USD 560 (350 + 210).

Foreign Currency Transaction Example – Export Sales

A similar process applies for a foreign currency transaction when a business undertakes export sales to overseas customers. Suppose the business uses USD as its reporting currency and exports goods to the UK, agreeing a sale value of GBP 5,000.

The relevant exchange rates to convert USD to GBP are as follows.

1. Initial transaction date: 1 GBP = 1.30 USD
2. Year end date: 1 GBP = 1.25 USD
3. Settlement date: 1 GBP = 1.22 USD

Initial transaction Date

At the transaction date the conversion calculation is as follows.

```Exchange rate GBP to USD = 1.30
GBP = 5,000
USD = 1.30 x GBP
USD = 1.30 x 5,000 = 6,500
```

Foreign Currency Transaction Journal Entry #1

To reflect to sale of the goods the following transaction is now posted in the reporting currency (USD) of the business.

Foreign currency transaction – Initial sale
Account Debit Credit
Accounts receivable 6,500
Revenue 6,500
Total 6,500 6,500

The business has made a sale of GBP 5,000 and at the initial transaction date exchange rate the value of that sale was USD 6,500. The journal reflects the revenue from the sale and the amount due from the export customer at current exchange rates.

Year End Date

At the year end date the exchange rate calculation is as follow.

```Exchange rate GBP to USD = 1.25
GBP = 5,000
USD = 1.25 x GBP
USD = 1.25 x 5,000 = 6,250
```

At the year end exchange rate the business is owed the smaller amount of 6,250 compared to the amount of 6,500 currently reflected in its accounting records. The difference of USD 250 is referred to as an unrealized exchange rate loss as the amount is yet to be settled.

Foreign Currency Transaction Journal Entry #2

To adjust for the exchange rate loss at the year end the following foreign currency transaction is recorded.

Foreign currency transaction – Year end date
Account Debit Credit
Foreign currency transaction loss 250
Accounts receivable 250
Total 250 250

At the year end the balance on the accounts receivable account with the export customer is USD 6,500 – 250 = USD 6,250. The exchange rate loss is recorded in the income statement of the business under the heading of foreign currency transaction loss.

Settlement Date

Subsequent to the year end the business receives payment from the the overseas customer. The amount due is GBP 5,000 but since the business reports in USD it must now convert the amount using the exchange rate at the settlement date.

The value of the accounts receivable asset due from the customer is now calculated as follows.

```Exchange rate GBP to USD = 1.22
GBP = 5,000
USD = 1.22 x GBP
USD = 1.22 x 5,000 = 6,100
```

Due to the change in exchange rate between the year end date (1.25) and the settlement date (1.22) the business only receives USD 6,100 to settle the outstanding amount of GBP 5,000. The amount due is currently reflected in its accounting records at USD 6,250, and the difference of USD 150 is a further foreign currency transaction loss.

Foreign Currency Transaction Journal Entry #3

Foreign currency transaction – Settlement
Account Debit Credit
Accounts receivable 6,250
Foreign currency transaction loss 150
Cash 6,100
Total 6,250 6,250

The balance on the overseas customer account of 6,250 has now been cleared by a payment of USD 6,100 (GBP 5,000) and the foreign currency transaction loss of 150.

It should be noted that the business sold goods for GBP 5,000 and received GBP 5,000. The foreign currency transactions arise because the reporting currency of the business is USD and the exchange rate varies between the initial sale date (1.30), the year end date (1.25) and the settlement date (1.22). The net effect is the business recorded revenue of USD 6,500 and received only USD 6,100, recording a total foreign currency transaction exchange loss of USD 400 (250 + 150). Since the amount has now been settled the exchange loss has now been realized.

Summary

In the above examples the foreign currency (GBP) weakens from 1.30 to 1.22. The effect of this was to create a foreign currency transaction gain on the import purchase, and a foreign currency transaction loss for the export sale.

The effect on transactions of changes in the strength of the foreign currency exchange rate is summarized in the table below.

Effect of foreign currency strength on transactions
Strengthens Weakens
Import purchase Loss Gain
Export sale Gain Loss
Foreign Currency Transaction Bookkeeping July 25th, 2017