When a business conducts business in a currency they do not normally use, the company will have a foreign currency transaction gain or loss. The gain or loss comes from a change in the spot rate of the foreign currency from the day the business enters into the transaction and the day the business pays in the foreign currency.
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Recording the Initial Transaction
Debit "Purchases," and credit "Accounts Payable." The amount to debit and credit is based on the current exchange rate. For example, if $1 equals 1.2 euros and the company buys 10,000 euros of products, then debit $8,333.33.
Recording the Exchange for a Loss
When the exchange rate drops, for example to 1.1 euros to the dollar, the exchange will have a loss. Debit "Accounts Payable" and "Foreign Exchange Loss" then credit "Cash." Debit "Accounts Payable" for the same amount when recording the transaction and credit "Cash" for the amount of
cash actually paid. The difference between the "Cash" and "Accounts Payable" is the loss.
Recording the Exchange for a Gain
When the exchange rate rises, for example to 1.3 euros to the dollar, there will be a gain. Debit "Accounts Payable," credit "Cash" and "Gain on Foreign Exchange." The accounts payable is the same amount debited when initially recording the transaction. The "Cash" is the amount of cash exchanged due to the new exchange rate. The difference between "Accounts Payable" and "Cash Paid" is the gain on the exchange.
Financial Statement Impact
Gains and losses are reported on the income statement. This will either increase or decrease net income for the period.
Gains and Losses Not on the Income Statement
The following are translation adjustments and are not income: economic hedges for an investment in a foreign entity, long-term inter-company transactions, and a gain or loss on a hedging instrument to a foreign currency contract.