Transaction gain or loss (measured from the transaction
date or the most recent intervening balance sheet date, whichever is later)
realized upon settlement of a foreign currency transaction usually should be
included in determining net income for the period in which the transaction is
settled.
Example:
An exchange gain or loss occurs when the exchange rate
changes between the purchase date and sale date. Merchandise is bought for
100,000 pounds. The “exchange rate” is 4 pounds to 1 dollar. The journal entry
is:
[Debit]. Purchases = 25,000
[Credit]. Accounts
payable = 25,000
(Note: 100,000/4 =
$25,000)
When the merchandise is paid for, the exchange rate is 5 to
1. The journal entry is:
[Debit]. Accounts payable = 25,000
[Credit]. Cash =
20,000
[Credit]. Foreign
exchange gain = 5,000
(Note: 100,000/5 =
$20,000)
The $20,000 using an exchange rate of 5 to 1 can buy 100,000
pounds. The transaction gain is the difference between the cash required of
$20,000 and the initial liability of $25,000.
Note that a foreign transaction gain or loss has to be
determined at each balance sheet date on all recorded foreign transactions that
have not been settled.
Another example:
A U.S. company sells goods to a customer in England on
11/15/X7 for 10,000 pounds. The exchange rate is 1 pound is $0.75. Thus, the
transaction is worth $7,500 (10,000 pounds × 0.75). Payment is due two months
later. The entry on 11/15/X7 is:
[Debit]. Accounts receivable—England = 7,500
[Credit]. Sales =
7,500
Accounts receivable and sales are measured in U.S. dollars
at the transaction date employing the “spot rate“. Even though the accounts
receivable is measured and reported in U.S. dollars, the receivable is fixed in
pounds. Thus, a “transaction gain or loss” can occur if the exchange rate
changes between the transaction date (11/15/X7) and the settlement date
(1/15/X8).
Since the financial statements are prepared between the
transaction date and settlement date, receivables that are denominated in a
currency other than the functional currency (U.S. dollar) have to be restated
to reflect the spot rate on the balance sheet date. On December 31, 20X7, the
exchange rate is 1 pound equals $0.80. Hence, the 10,000 pounds are now valued
at $8,000 (10,000 × $.80). Therefore, the accounts receivable denominated in
pounds should be upwardly adjusted by $500. The required journal entry on
12/31/X7 is:
[Debit]. Accounts receivable—England = 500
[Credit]. Foreign
exchange gain = 500
The income statement for the year-ended 12/31/X7 shows an
exchange gain of $500. Note that sales is not affected by the exchange gain
since sales relates to operational activity.
On 1/15/X8, the spot rate is 1 pound = $0.78. The journal
entry is:
[Debit]. Cash = 7,800
[Debit]. Foreign
exchange loss = 200
[Credit]. Accounts
receivable—England = 8,000
The 20X8 income statement shows an exchange loss of $200.
Which Transaction Gain Or Loss Should Not Be Reported In The
Income Statement?
Gains and losses on the following foreign currency
transactions “ARE NOT“ included in earnings but rather are reported as
translation adjustments:
1.Foreign currency transactions designated as economic
hedges of a net investment in a foreign entity, beginning as of the designation
date.
2.Inter-company foreign currency transactions of a long-term
investment nature (settlement is not planned or expected in the foreseeable
future),when the entities to the transaction are consolidated, combined, or
accounted for by the equity method in the reporting company’s financial
statements
3.A gain or loss on a forward contract or other foreign
currency transaction that is intended to hedge an identifiable foreign currency
commitment (e.g., an agreement to buy or sell machinery) should be deferred and
included in the measurement of the related foreign currency transaction.
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