If you do any sort of business with overseas companies, you’ll likely end up sending or receiving payments in a currency that’s different from your home currency. Since exchange rates can fluctuate day-by-day or even hour-by-hour, it’s important to keep careful records of how much money you’re gaining or losing when payments are sent, received or converted in foreign currencies.
Foreign exchange accounting can be daunting to a beginner, but with the right information and a little practice, keeping track of your foreign transactions can become second nature. Read on to learn what beginners need to know about foreign exchange accounting.
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Now, back to what you came here to read.
What to know about exchange rates
At the core of foreign exchange accounting is exchange rates, which change all the time.
Who sets exchange rates?
Exchange rates can be set a few different ways, and it depends on what exchange rate you’re looking at — yes, there can be a few different exchange rates at any given time. Don’t worry — it’s not as complex as it sounds.
The mid-market rate
The mid-market rate is the “actual” exchange rate — the same rate you see when you Google the exchange rate between two currencies. Traders set this rate; they decide what rates at which they’re willing to “buy” and “sell” each currency, and the mid-market rate is the midpoint between the supply and demand for the currency. This is also sometimes called the spot rate. It’s also referred to as the interbank rate because this is the rate banks use to trade currencies with one another. But that doesn’t necessarily mean this is the rate banks will use when they trade currency with you, the customer. More on that below.
Exchange rate markups
When banks sell foreign currencies to customers, as well as when they convert international payments into a different currency, they usually don’t convert the funds at the mid-market rate. Instead, they often mark up the exchange rate (by an average of 4-6%!) allowing them to make a profit on the conversion. To see if your bank is marking up its exchange rates, compare your offered exchange rate to the mid-market rate using an online currency converter.
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How exchange rates can affect your accounting
When making or receiving payments in foreign currencies, fluctuations in the foreign exchange rate can affect your bottom line. Here’s how.
Foreign exchange accounting
Let’s say your US-based business is receiving a payment from a company in the UK, equalling $100,000. Your accounting journal entry for this transaction probably looks something like this:1
| Debit | Credit | |
|---|---|---|
| Accounts Receivable | $100,000 | |
| Sales | $100,000 |
At the time the transaction is entered and invoiced, the exchange rate is 1 USD = 0.72 British pound sterling. That means you’d invoice the UK company for £72,000.
However, between the time the payment is entered and the time the payment is received, the foreign exchange rate has fluctuated. It is now 1 USD = 0.65 British pound sterling. Since you invoiced the UK-based company for £72,000, that’s what it sends for the payment, even though that now converts to $110,769.23with the new exchange rate. You just gained $10,769.23.22 due to a fluctuation in the exchange rate, and your accounting needs to reflect that. Here’s what your new accounting journal entry might look like:1
| Debit | Credit | |
|---|---|---|
| Cash | $110,769.23 | |
| Foreign Exchange Currency Gain | $10,769.23 | |
| Accounts Receivable | $100,000 |
On the other hand, the exchange rate could fluctuate in the other direction. By the time the UK-based company pays, let’s say the exchange rate is now 1 USD = 0.77 British pound sterling. That means the £72,000 the UK-based company sends you will now convert to $93,506.49, giving you $6,493.51 less than the $100,000 that you originally invoiced. So in this case, your accounting journal entry will look like this:1
| Debit | Credit | |
|---|---|---|
| Cash | $93,506.49 | |
| Foreign Exchange Currency loss | $6493.51 | |
| Accounts Receivable | $100,000 |
You can see how fluctuations in the foreign exchange rate can affect your bottom line, and that’s only if you’re able to convert your currency at the mid-market rate. Marked-up exchange rates can take an even bigger bite out of your profits, making it all the more important to find a way to make international money transfers and payments without marked-up exchange rates or other hidden fees.
Even for beginners, foreign exchange accounting doesn’t have to be as complicated as it sounds. Hopefully, this resource helps, and if you need more help, there are plenty of resources available.1 Good luck with your transactions!
Sources:
1.http://accounting-financial-tax.com/2008/10/what-is-journal-entry-for-foreign-currency-transactions/ (September 17 2018)
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