What is a Foreign Exchange Gain/Loss?
Foreign Exchange (FX) Gain/Loss is the difference in value when an entity indulges in trade with foreign transactions, which results in fluctuations in earned income due to a change in the value of foreign currency relative to the domestic currency.
Globalization has unlocked doors to many ample opportunities for trade and commerce. What once used to be region-specific, now anyone can experience what that region has to offer from miles away.
Globalized trade has opened doors for opportunities, but it has also brought with it issues and inefficiencies, such as different accounting standards, trade regulations, etc.
To tackle such issues, countries recognized unified standards and currency to ensure smooth international trade, increasing a nation's diversity and productivity.
The move toward globalization was made possible through diplomatic relations, trust, and a unified internationally accepted currency, i.e., US dollars. Therefore, countries need to increase their foreign currencies through trade.
Why Foreign Exchange Matters
“Why should a local company need to think about foreign exchange rates? Their customer base is in the local market”. It does. That is the simplest answer to that question. In reality, foreign exchange rates affect every business one way or another.
With the emergence of globalization, many commodities available in a market can be imported from foreign countries, as certain commodities are better imported than produced at home. This can indirectly affect businesses whose materials are imported from foreign countries.
The world accepted the US Dollar to be the unifying medium of international trade, thanks to President Nixon, who removed the dollar's reliance on gold in 1971, marking the end of the global gold standard.
Now every country's currency is backed by the dollar (due to various factors), and they have been tasked with maintaining their foreign reserves. Thus, international trade is ensured to go on.
“Why should businesses worry about such an issue?” Well, they should, especially when the Gold standard no longer backs currencies, but fiat money (USD) does. Fiat money, which lacks the strength of precious commodities, is therefore more unstable than gold.
The effect of USD on the home currencies can make or break any business’s revenue. How? Let's find out about it.
Understanding Foreign Exchange Gain/Loss
As mentioned above, a foreign exchange (FX) gain/loss is the difference in value when an entity indulges in trade from a foreign country, which results in fluctuations in earned income due to a change in the value of the foreign currency relative to the domestic currency.
The resulting fluctuations can affect the entity’s monetary value of assets and liabilities, which should be settled by recognizing them at periodic intervals. "But what exactly is an exchange rate?"
An Exchange Rate is the difference in the value of a currency that occurs from converting a foreign currency to a local currency via foreign transactions. This difference occurs when the value of one currency is higher than the other due to many factors.
The resulting variance from a conversion that ends up being a positive amount is considered a gain. But if the resulting variance is negative, it is considered a loss.
Taking the next exchange rate is ideal when any issues are encountered while calculating the current exchange rate at the time of transaction recognition, as foreign exchange rates are unstable and do not stay the same for a long period.
How Currency Exchange Affects Businesses
Normally, fully domestic-based businesses, i.e., suppliers and customers, are local, so the effect is minimal from foreign exchange. But that is in an ideal world.
Foreign exchange affects every business in one way or another, whether directly or indirectly, based on the business’s operations.
The most prominent businesses that are affected by foreign exchange are MNCs (multinational corporations) or any businesses that have a global customer base.
These companies trade with foreign customers and receive compensation for the transactions in the foreign currency rather than that of the business’s local currency.
Imagine a US-based marshmallow producer received a bulk order worth $560, including tax and shipping, from a customer in Mexico. The customer received a 15-day credit period for the purchase.
By the time the customer pays, there can be minor changes in the exchange rate, affecting the marshmallow producer by receiving less or more than what was anticipated.
Realized and Unrealized Foreign Exchange Gain/Loss
The day-old issue when it comes to recording the transaction at year-end is “Should I record today’s sale in this year or next year when the customer pays?” Using an accrual basis when reporting financial statements (except the Cash Flow Statement) is a simple strategy.
The same dilemma can be found in realizing the transactions when the trade goes out of territorial boundaries. Therefore, the realized and unrealized gains or losses of the transactions in foreign currencies depend on whether the transaction has been completed by the year's end.
Let us understand what a realized transaction is and what an unrealized transaction is to understand the differentiating factor between each transaction better.
Realized Transactions
Realized transactions are those gains or losses from foreign transactions that are settled within the accounting period. These occurred gains and losses do not carry the pending balance to the next year. Such realized gains or losses are recorded in the income statement.
For instance, a UK-based customer places an order with a US-based seller for £350. The customer receives the product and pays the amount at the current exchange rate 15 days after the invoice date. The whole transaction occurred within the accounting period.
The amount the seller would have received if the customer paid upfront would have been $446.16, but the seller received $448.28 based on the exchange rate after 15 days. Therefore, the seller received a gain of $2.12, realizing the gain from foreign trade.
Unrealized Transactions
Unrealized transactions are those gains or losses from foreign transactions that are yet to be settled within an accounting year. These gains and losses are incurred after the accounting period ends and, therefore, are required to carry forward the balances to the next year.
These typically happen when the customer pays off the settlement after a business’s accounting period. Any unrealized gains or losses are posted under the equity section of the company’s Statement of Financial Position (Balance Sheet).
During unrealized transactions, the company would assess what would have been received if the customer had paid within the accounting period to grasp how much sustenance it would have brought.
For instance, an Irish company produced goods worth €2000, which was later issued at an invoice of $2,200. The customer, who is based outside of Ireland, failed to make payments within the company’s accounting period.
Therefore, the billed invoice is valued at $2000 in the financial statements and the resulting loss of $200 was due to the unrealized losses as the payment is yet to be received.
Recording Foreign Exchange Transactions
During the recognition of foreign transactions in the financial statements, the entry posted for such transactions should be in the home currency to avoid unwanted confusion among shareholders.
Therefore, the exchange value of the transactions of the financial statements should be posted at the time of posting into financial statements.
For instance, XY Econ, a Norwegian-based automobile manufacturer, manufactures automobiles from production plants in South Korea. During the month's end, XY Econ transfers salary packages to employees in South Korea.
However, the amount realized in the financial statements of XY Econ was at the foreign exchange rate of XY Econ’s accounting year end, i.e., December 20XX.
To learn more about the accounting treatment of the foreign exchange gains/losses as per the accounting standard, kindly refer to Deloitte’s IAS PLUS, which explains IAS 21, “The Effects of Changes in Foreign Exchange Rates.”
Example of Foreign Exchange Gain/Loss
VTX Corp, a Canadian-based PC manufacturer specializing in gaming rigs, has operations in North America, Europe, and Asia Pacific regions. VTX Corp manufactures gaming rigs in Japan to produce efficient production at a low cost compared to in-house production.
VTX Corp purchased 600 units of Ryzen 7 7700X processors from the AMD Taiwanese branch for 7,542,720 TWD on credit. At the time of invoice, the exchange rate for 1 Canadian dollar was equal to 23.28 New Taiwanese Dollars.
The credit period was 60 days, after which VTX Corp paid the amount of 7,627,307.17 TWD, i.e., 1 CAD equals 23.54 TWD.
Therefore, the gains/losses for VTX Corp are:
= Invoice amount - Amount Paid
= CAD 320,406.83 - CAD 324,000
= - CAD 3,593.17 [Foreign exchange loss]
Researched and authored by Muhammed Ishfaque Ishaque | LinkedIn
Reviewed and edited by Mohammad Sharjeel Khan | LinkedIn
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