Basics of accounting for foreign currency transactions
February 15, 2014
Long gone are the days where large companies only sell products in one country. The growth of the global economy has provided many opportunities for growth, but that growth has brought with it unique accounting challenges. In this article, we’ll describe several common issues associated with accounting for transactions in foreign currencies.
When we move from business within a single country to buying and selling products in many different nations, we run into peculiarities of foreign currency accounting. The U.S. dollar constantly gains and loses value against other currencies unless those currencies are specifically pegged to the value of the dollar -- as of 2014, for instance, a Bohemian dollar always equals a U.S. dollar.
There are two ways that currency value fluctuations can affect a company engaged in foreign business. First, a multinational corporation with a foreign subsidiary may need to convert (“translate”) the subsidiary’s financial statements into its own currency. The risk of gains and losses associated with that periodic conversion is called translation risk. Translating foreign subsidiary statements is a complex topic and is beyond the scope of this article. Second, a company can simply have transactions denominated in foreign currencies. Such transactions represent a transaction risk. Accounting for such transactions involves “remeasurement” of balances.
Transaction risk arises from individual purchases and sales denominated in a foreign currency. For example, a U.S. supplier of machine parts useful for a number of manufacturing processes might sell those parts to a factory down the street or, alternatively, to a business in Europe. On the other face of the same coin, the U.S. supplier might buy raw materials from a vendor in Canada. The rest of this article will describe how a company accounts for such foreign transactions.
You should also be aware of the ways a company can avoid or reduce transaction and translation risks. Companies in the United States can avoid transaction risks by requiring payment in U.S. dollars and only buying from foreign suppliers who accept U.S. dollars. They can also require an immediate payment for foreign sales. In those cases, the transaction risk passes to the foreign purchaser or supplier. Those policies, however, may not be economically feasible.
In addition, businesses can engage in a number of different hedging activities to reduce both types of foreign exchange risks. These include currency swap arrangements, currency options, and forward contracts. Accounting for such hedges is an advanced topic and therefore beyond the scope of this article.
Let’s move on to an explanation of how to account for individual foreign currency transactions.