Definition of Foreign Exchange Gains and Losses
Foreign exchange gains and losses are referred to as losses that are incurred when a company purchases goods and services in foreign currency. The currency fluctuation exists on a normal basis, and as a result of this fluctuation, there is a difference in monetary assets and liabilities, which are recognized on a periodic basis unless they are eventually settled.
The exchange rate is recognized as the price of one currency in terms of another currency. In the case where the price of local currency increases with respect to a foreign currency, it is referred to as currency appreciation. On the other hand, if the price of the local currency decreases with respect to any other foreign currency, it is referred to as currency depreciation.
During the normal course of the business, there are several transactions that take place in foreign exchange. Mostly, these are forward contracts that are signed by the company in advance. However, since the exchange rate is volatile, it often results in a difference between the actual amount paid, and the amount that would have been paid if the foreign exchange had not changed.
Therefore, the difference between the amount that was actually paid, and the amount that would have been paid is similar to the foreign exchange gain or loss of the company.
Impact of Foreign Exchange on Businesses
Foreign Exchange risk is one of the most critical risks for a company. Factually, it can be seen that companies work day in and out in order to ensure that this risk is minimized to an optimum level. This is primarily because of the fact that it greatly impacts the overall profitability of the company.
Using spot and forward rates is one approach adopted by companies to hedge against this particular risk. However, this risk cannot be eliminated altogether. Therefore, companies dealing with foreign exchange have a greater exposure towards volatility in terms of pricing, sourcing, and hence, profitability.
In some cases, companies are able to pass on this burden to the customers, but in some cases, the foreign exchange loss is for the company to bear. The extent of the burden is contingent on the elasticity of the product. If the product is price elastic, the company might not be able to change its prices as a result of foreign exchange currency. On the contrary, if the product does not price inelastic, it eventually results in the company bearing the burden of a foreign exchange loss.
Journal Entries to record Foreign Exchange Accounting
In order to record Foreign Exchange Loss, the following journal entries are made:
| Account | Debit | Credit |
| Cash | xxx | |
| Foreign Exchange Loss | xxx | |
| Accounts Receivable | xxx |
On the contrary, in case of any Foreign Exchange Gain, the following journal entries are made:
| Account | Debit | Credit |
| Cash | xxx | |
| Foreign Exchange Gain | xxx | |
| Accounts Receivable | xxx |
Realized and unrealized Foreign Exchange Gains or Losses
Realized and unrealized Foreign Exchange Gains or Losses from currency-related transactions differ contingent on the transaction status at the end of the accounting period.
Unrealized Gains and Losses
Unrealized gains and losses is the amount that the seller expects to earn when the invoice is settled, but the customer had failed to settle the amount by the close of the accounting period. The seller calculates the gains and the losses that would have been incurred if the customer had paid the invoice at the end of the accounting period.
When financial statements are prepared for the respective period, the transaction is recorded as an unrealized gain or loss. The unrealized gains and losses are recorded in the balance sheet under the section of Owner’s Equity.
Realized Gains and Losses
Realized Gains and Losses are defined as the gains or losses on transactions that have been completed. This implies that the customer had already settled the amount before the accounting period ended.
In case of realized gains or losses, the respective currency gain or loss is recorded in the income section of the income statement.
Example of Foreign Exchange Gains and Losses
Frisky Co. has two main suppliers, in Pakistan, and in China. Frisky Co. is based in the U.S. When they purchased goods and services from Pakistan, the exchange rate was as follows:
$1 = PKR (Pakistani Rupee) 150
$1 = CNY 10
They purchased goods worth PKR 100,000 from Pakistan, and CNY 20,000 from China.
However, when they paid these suppliers, the exchange rate was as follows:
$1 = PKR (Pakistani Rupee) 170
$1 = CNY 5
It can be seen that in the scenario mentioned above, when the goods were actually purchased, Frisky Co. had to pay an amount of $667 to Pakistan in exchange of goods and services that were imported.
On the other hand, Frisky Co. had to pay an amount equivalent to $2000 to China.
However, when the actual payment was made, Frisky Co. ended up paying $588 to Pakistan, and $4000 to China.
This implies that with Pakistan, they had a Foreign Exchange profit equivalent to ($667 – $588) $59, whereas with China, they had a Foreign Exchange loss equivalent to ($2000 – $4000) $2000.
In order to record the aforementioned gain and losses, the following journal entries are made:
| Account | Debit | Credit |
| Accounts Payable – Pakistan | $667 | |
| Foreign Exchange Gain | $59 | |
| Bank | $588 |
The journal entry above shows the profit that is made as a result of the exchange rate appreciation against the PKR.
| Account | Debit | Credit |
| Accounts Payable – China | $2,000 | |
| Foreign Exchange Loss | $2,000 | |
| Bank | $4,000 |
The journal entry above shows the loss that is made as a result of the exchange rate depreciation against the CNY.
