About Realized and Unrealized Gains and Losses

This topic covers realized and unrealized currency exchange gains and losses.

When a company headquartered in one (domestic) country executes a transaction with a company in another (foreign) country using a currency other than the domestic currency, one currency needs to be converted into another to settle the transaction. This conversion from one currency to another creates gains and losses depending on the currency exchange rate.

Realized Currency Exchange Gains and Losses

Realized currency exchange gains and losses can occur when full or partial payments are applied to voucher or invoice amounts.

Note:  Gains and losses are calculated on each payment amount instead of the outstanding voucher or invoice amount.

Balance Paid in Full

In the following examples, the transactions were completed by the receipt of the payment of cash. Therefore, any exchange gain or loss was realized and, in an accounting sense, was recognized on the date of the cash receipt or cash payment.

For example, a U.S. company purchasing items from a British company that requires payment in British pounds must exchange dollars ($) for pounds (£) to settle the transaction. This exchange of one currency into another involves the use of an exchange rate. If the U.S. company had purchased items for £1,000 from a British company on June 1, when the exchange rate was $1.40 per British pound, $1,400 would need to be exchanged for £1,000 to make the purchase.

Note:  The foreign exchange rates used in this example do not reflect current rates.

Because the U.S. company maintains its accounts in dollars, the transaction would be recorded as follows:

June 1 Purchases ......................... 1,400

Cash ............................................. 1,400

Payment of Invoice #1725 from Sterling Co.

£1,000; exchange rate: $1.40 per British pound

Special accounting problems arise when the exchange rate fluctuates between the date of the original transaction (such as a purchase on account) and the settlement of that transaction in cash in the foreign currency (such as the payment of an account payable). In practice, such fluctuations are frequent.

For example, assume that on July 10, when the exchange rate was $.004 per yen (¥), a purchase for ¥100,000 was made from a Japanese company. Since the U.S. company maintains its accounts in dollars, the entry would be recorded at $400 (¥100,000 X $.004), as seen below:

July 10 Purchases .......................................... 400

Accounts Payable - M. Suzuki ......................... 400

Invoice #823

¥100,000, exchange rate: $.004 per yen

If on the date of payment, August 9, the exchange rate had increased to $.005 per yen, the ¥100,000 account payable must be settled by exchanging $500 (¥100,000 X $.005) for ¥100,000. In this case, the U.S. company incurs an exchange rate loss of $100, because $500 was needed to settle a $400 debt (accounts payable). The cash payment would be recorded as follows:

August 9 Accounts Payable - M. Suzuki ......................... 400

Exchange Loss .............................................................. 100

Cash .............................................................................. 500

Cash paid on Invoice #823

¥100,000, or $400, current exchange rate: $.005 per yen

All transactions with foreign companies can be analyzed as in the examples above. For example, assume that on May 1, when the exchange rate was $.25 per euro (‚¬), a sale on account for $1,000 from a U.S. company to a French company was billed in euros (‚¬4,000). The transaction would be recorded as follows:

May 1 Accounts Receivable - Crusoe Co. .................... 1,000

Sales .......................................................................... 1,000

Invoice #7782

‚¬4,000, exchange rate: $.25 per euro

If the exchange rate had increased to $.30 per euro on May 31, the date of receipt of cash, the U.S. company would realize an exchange gain of $200. The gain was realized because the ‚¬4,000, which had a value of $1,000 on the date of sale, had increased in value to $1200 (‚¬4,000 * $.30) on May 31 when payment was received. The receipt of the cash would be recorded as follows:

May 31 Cash .................................................. 1,200

Accounts Receivable - Crusoe Co. .................. 1,000

Exchange Gain .................................................. 200

Cash received on Invoice #7782

‚¬4,000 or $1,000, exchange rate: $.30 per euro

Partial Payments

When the balance is not paid in full, however, the system calculates currency gains and losses on each payment amount instead of the outstanding voucher or invoice amount. The system uses the following formula when performing the gain/loss calculation:

Gain/Loss Amount = (Payment / Average Exchange Rate) - (Payment / Payment Exchange Rate)

where:

Average Exchange Rate = Foreign Amount Outstanding Balance / Domestic Outstanding Balance

For example, a German company purchasing items from an U.S. company pays in euros (‚¬). The U.S. company must then exchange euros for U.S. dollars to settle the transaction. In this case, the German company is making partial payments rather than paying the balance in full. The transaction would occur as follows:

Partial Payment Transaction: Euros to U.S. Dollars

  Foreign Amount (euro)    Exchange Rate    Domestic Amount (U.S Dollar)     
Invoice #1800 ‚¬1100.00 ‚¬2:$1 $550.00  
Credit Memo 200.00 4:1 50.00  
Balance 900.00   500.00 Avg. Exch. Rate: 900:500 = 1.8
Payment 600.00 3:1 200.00  
Loss     133.33 Loss: (600/1.8) - (600/3) = 133.33
Balance 300.00   166.67 Avg. Exch. Rate: 300:166.67 = 1.8
Payment 300.00 3:1 100.00  
Loss     66.67 Loss: (300/1.8) - (300/100) = 66.67
Balance 0.00   0.00  

The German company purchases items from the U.S. company for ‚¬1100 at an exchange rate of ‚¬2.00 per $1.00. After a credit memo for ‚¬200 is issued, a credit is shown for $50 due to a exchange rate of ‚¬4.00 per $1.00, resulting in a balance of ‚¬900 ($500).

Before calculating the gain/loss amount, the system must first calculate the average exchange rate by dividing the foreign balance by the domestic balance (‚¬900 / $500 = 1.8 average exchange rate). After a payment of ‚¬600 at an exchange rate of ‚¬3.00 per $1.00, the loss is $133.33. The system calculates the loss by (Payment Amount/Avg. Exchange Rate) - (Payment Amount/Payment Exchange Rate) or (600/1.8) - (600/3) = 133.33. The resulting balance is ‚¬300 or $166.67.

Again, before calculating the gain/loss, the system must first calculate the average exchange rate by dividing the foreign balance by the domestic balance (‚¬300 / $166.67 = 1.8 average exchange rate). The final payment of ‚¬300 at an exchange rate ‚¬3.00 to $1.00 settles the transaction, resulting in a loss of $66.67. The system calculates the loss by (Payment Amount/Avg. Exchange Rate) - (Payment Amount/Payment Exchange Rate) or (300/1.8) - (300/100) = 66.67.

Unrealized Currency Exchange Gains and Losses

However, if financial statements are prepared between the date of the original transaction (sale or purchase on account, for example) and the date of the cash receipt or cash payment, and the exchange rate has changed since the original transaction, an unrealized gain or loss must be recognized in the statements.

For example, assume that a sale on account for $1,000 had been made to a German company on December 20, when the exchange rate was $.50 per euro (‚¬), and that the transaction had been recorded as follows:

Dec. 20 Accounts Receivable - Mueller Co. ............. 1,000

Sales ...................................................................... 1,000

Invoice #22

‚¬2,000; exchange rate: $.50 per euro

If the exchange rate had decreased to $.45 per euro on December 31, the date of the balance sheet, the $1,000 account receivable would have a value of only $900 (‚¬2,000 X $.45). This "unrealized" loss would be recorded as follows:

Dec. 31 Exchange Loss ............................... 100

Accounts Receivable - Mueller Co. ............... 100

Invoice #22

‚¬2,000 X $.05 decrease in exchange rate

Assuming that ‚¬2,000 are received on January 19 in the following year, when the exchange rate is $.42, the additional decline in the exchange rate from $.45 to $.42 per euro must be recognized. The cash receipt would be recorded as follows:

Jan. 19 Cash ............................................. 840

Exchange Loss ($.03X‚¬2,000) .................... 60

Accounts Receivable - Mueller Co. ............ 900

Cash received on Invoice #22

‚¬2,000, or $900, exchange rate: $.42 per euro

If the exchange rate had increased between December 31 and January 19, an exchange gain would be recorded on January 19. For example, if the exchange rate had increased from $.45 to $.47 per euro during this period, an exchange gain would be credited for $40 ($.02 X ‚¬2,000).

A balance in the exchange loss account at the end of the fiscal period should be reported in the Other Expenses section of the income statement. A balance in the exchange gain account should be reported in the Other Income section.

Consolidated Financial Statements with Foreign Subsidiaries

Before the financial statements of domestic and foreign companies are consolidated, the amounts shown on the statements for the foreign companies must be converted to domestic currency. Asset and liability amounts are normally converted to domestic currency by using the exchange rates as of the balance sheet date. Revenues and expenses are normally converted by using the exchange rates that were in effect when those transactions were executed. (For practical purposes, a weighted average rate for the period is generally used.) The adjustments (gains or losses) resulting from the conversion are reported as a separate item in the stockholders' equity section of the balance sheets of the foreign companies.

After the foreign company statements have been converted to domestic currency, the financial statements of domestic and foreign subsidiaries are consolidated in the normal manner.