Accounting for Foreign Currency Transactions and Exchange Rates

Feb 9, 2021

By Jennifer Birmingham, CPA
February 11, 2021

 The world as we know it has changed significantly within the last year with the spread of the COVID-19 virus and pandemic. Individual governments have reacted to the virus to protect the health and economic welfare of their citizens using different methods. But it feels like we are globally confronting like problems with solutions – decreases in social outings, tourism, and shopping; changes to how live sports events and concerts are presented; increased work for medical professionals and industries that support the medical profession. The long-term effects of the pandemic are unknown, but we are currently seeing a general economic downturn. Central banks for governments are reducing interest rates resulting in fluctuations in global currencies.

Many of our clients transact business outside of the United States. We advise these businesses on accounting for international sales, purchases, and other transactions with both related and unrelated parties. Many of these transactions are transacted in U.S. dollars, but others are transacted in foreign currencies. There are risks associated with trading in foreign currencies, especially right now with so many unknowns occurring in the global economy.

How can we help companies reduce these risks? How can we advise businesses to account for these risks in their accounting system? Below is some helpful information.

Foreign Currency Risk

There is always a risk to working with a currency other than your own. For example, a company orders an item for €100 when the exchange rate on €100 is $99. So, the company expects to spend $99 on the item. By the time the item arrives, and the company pays for it, the exchange rate may have changed so that €100 is worth $110. This means that the company is buying the item for $110 instead of the original $99, an $11 increase in cost merely based on the change in exchange rates.

We hope that exchange rates between USD and EUR do not actually fluctuate as dramatically as in the above example. However, we can see that from January 13, 2020 to January 13, 2021, the actual USD to EUR exchange rate increased from approximately $1.12/EUR to $1.22/EUR. This means that an item priced at €1 would cost $1.12 on January 13, 2020, but would cost $1.22 one year later. If a company bought €100,000 of inventory from a vendor January 13, 2020, but did not pay for it until January 13, 2021, it would need to pay an additional $10,000 just due to the passage of time.

The volatility and frequency of exchange rate valuations vary with the change in stability of local and world economics. Tariff wars and climate change related disasters are among the many factors that cause currency fluctuation. Other factors include a country’s monetary policy, inflation rate, and other political and economic conditions.

Reducing Risk

There are a few ways to handle exchange rate risks:

  1. Do nothing and hope that your home currency (the dollar) is stronger than the foreign currency you are transacting in. This can be referred to as praying or gambling.
  2. Require all foreign currency vendors, customers, etc. to transact with your company in U.S. dollars. This will push the risk of foreign currency fluctuations to the other company, but could limit your company’s ability to work with certain vendors, customers, markets, etc.
  3. Require your customers who are paying in a foreign currency to prepay or pay promptly to reduce the risk time plays in foreign currency fluctuations.
  4. Add a foreign currency transaction fee to all sales conducted in a foreign currency to cover any potential losses.
  5. Work with a bank that specializes in managing exchange risks. Certain banks offer extensive consulting in reducing exchange risk while offering tools to hedge risk – forward contracts, options, etc.

Accounting for Foreign Currency Transactions

For U.S. Generally Accepted Accounting Principles (GAAP) purposes, when an exchange rate changes between the date of the original transaction and the date of settlement, the difference is recorded as a gain or loss on exchange.

For example, Company X sells a €100 item to Customer Y at a time when €100 equals $110. Company X records a receivable of $110 on the balance sheet and a sale of $110 on the income statement. Ninety days later when the exchange rate is 1:1 and €100 equals $100, Customer Y pays Company X €100. Company Y records a cash receipt of $100, clears out the receivable of $110, and records an exchange rate loss of $10 on the income statement.

If there are unsettled foreign currency transactions at the end of a reporting period, an unrealized exchange rate gain or loss needs to be recorded. This means that if a receivable or payable is expected to be settled in a foreign currency, but has not been paid or collected by the end of the reporting period, an unrealized exchange rate gain or loss is recognized. Unrealized exchange rate gains or losses are calculated the same way that realized exchange rate gains and losses are calculated.

We recommend recording realized and unrealized exchange rate gains and losses to separate accounts for record keeping purposes. Realized gains and losses are reported the same way for income tax and GAAP purposes, while for income tax purposes, unrealized gains and losses are carried forward to the period in which they are settled, at which time the realized gain or loss is recognized.

Foreign currency transactions can be very impactful to your financial statement and income tax reporting. Proper planning and understanding can help you manage that impact. If you have any questions about foreign currency transactions, please contact your MichaelSilver professionals at 847.982.0333.

Jennifer Birmingham, CPA joined MichaelSilver in January 2005 after earning her B.S. in Accounting from the University of Illinois at Chicago where she also received a MSA in May 2005. Jennifer is currently a Manager at MichaelSilver. Her responsibilities include supervising and performing the audit, review, and compilation of financial statements and performing business and accounting consulting services for various industry clients.