Foreign currency transactions are a crucial part of international business. They involve buying, selling, borrowing, or lending in a currency different from a company's functional currency, impacting financial statements and creating exchange rate risks.

Understanding how exchange rates work is key to managing these transactions. Economic factors, political events, and market speculation all influence currency values. Companies must carefully record foreign currency dealings and handle any resulting gains or losses.

Factors influencing exchange rates

Economic and political influences

• Economic factors (interest rates, inflation rates, GDP growth) significantly impact exchange rates between currencies
• Political stability and government policies affect the perceived value of a country's currency in the global market
• Balance of trade between countries influences the demand for and supply of currencies, affecting exchange rates
• Central bank interventions (quantitative easing, interest rate adjustments) can deliberately impact a country's currency value
• Global economic events, natural disasters, or geopolitical tensions cause sudden shifts in currency exchange rates (Brexit, COVID-19 pandemic)

Market dynamics and speculation

• Market speculation and investor sentiment play a crucial role in short-term exchange rate fluctuations
• Currency traders and investors analyze economic indicators to predict future currency movements (unemployment rates, consumer price index)
• Technical analysis of currency charts and historical price patterns influence trading decisions
• Carry trades, where investors borrow low-interest currencies to invest in high-interest currencies, can impact exchange rates
• Currency pairs with high trading volumes (EUR/USD, USD/JPY) often experience more frequent price fluctuations

Recording foreign currency transactions

Exchange rate selection

• Spot rate, the current exchange rate for immediate delivery of currencies, typically used for recording foreign currency transactions
• Forward exchange rates, predetermined rates for future currency exchanges, used for transactions involving future cash flows
• Transaction date rate used to initially record foreign currency transactions in the functional currency of the reporting entity
• Average exchange rates for a period may be used if exchange rates do not fluctuate significantly (monthly or quarterly averages)
• Choice between historical exchange rates and current exchange rates depends on the nature of the account being translated (monetary vs. non-monetary)

Practical considerations and compliance

• Proper documentation and disclosure of exchange rates used in financial statements essential for transparency and compliance with accounting standards
• Consistent application of chosen exchange rate methodology across reporting periods
• Consideration of materiality when deciding on the frequency of exchange rate updates for transaction recording
• Use of reliable sources for obtaining exchange rates (central banks, reputable financial institutions)
• Implementation of internal controls to ensure accuracy in foreign currency transaction recording and translation

Gains and losses on foreign currency

Calculation and recognition of gains/losses

• Foreign currency transaction gains or losses arise from changes in exchange rates between transaction date and settlement date
• Formula for calculating foreign currency gain or loss: $(Exchange Rate at Settlement - Exchange Rate at Transaction) × Foreign Currency Amount$
• Realized gains or losses occur when foreign currency transactions are settled
• Unrealized gains or losses recorded for unsettled transactions at the balance sheet date
• Foreign currency transaction gains and losses reported in the income statement as part of net income, unless specific hedge accounting provisions apply

Factors affecting gains/losses

• Volatility of exchange rates between functional currency and foreign currency impacts the magnitude of gains or losses
• Time lag between transaction initiation and settlement increases potential for exchange rate fluctuations
• Volume and value of foreign currency transactions influence the overall impact on financial statements
• Hedging strategies (forward contracts, currency options) may mitigate or alter the recognition of foreign currency gains and losses
• Functional currency concept crucial in determining whether a transaction results in a foreign currency gain or loss for a particular entity within a multinational corporation

Journal entries for foreign currency transactions

Initial recognition and subsequent measurement

• Initial recognition of foreign currency transaction converts foreign amount to functional currency using spot rate on transaction date
• Subsequent measurement of foreign currency monetary items at each balance sheet date uses closing rate and records resulting gains or losses
• Adjusting entries at period-end update carrying amounts of unsettled foreign currency monetary items and record unrealized gains or losses
• Non-monetary items carried at historical cost require no adjustment after initial recognition, preserving exchange rate used at transaction date

Settlement and specialized transactions

• Journal entries for settlement of foreign currency payables or receivables record actual amount of functional currency paid or received and recognize any gain or loss
• Complex transactions (foreign currency denominated loans, investments) may require specialized journal entries to account for both principal and interest components in foreign currency
• Hedging transactions involve additional journal entries to record the hedging instrument and its fair value changes
• Intercompany transactions in foreign currencies may require elimination entries in consolidated financial statements
• Translation of foreign subsidiary financial statements involves comprehensive journal entries to adjust all balance sheet and income statement items to the reporting currency