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Accounting for Foreign Exchange Transactions

What is a foreign currency transaction? It is when a Company enters into a transaction that is denominated in a currency other than the Company’s functional currency. A Company’s functional currency is the currency of the primary economic environment in which the entity operates. Transactions most commonly would include the buying or selling of goods or services along with related accounts payable and accounts receivables, as well as, borrowing or lending money. The foreign exchange gains or losses that result from these transactions can be treated differently for tax purposes depending on the basis of your financial statements. We are going to compare the differences in book and tax treatment when recognizing realized and unrealized gains and/or losses as a result from payable/receivables.

How is a foreign currency transaction recorded in a Company’s books and records? At the date a foreign currency transaction occurs, each asset, liability, revenue, expense, gain, or loss arising from the transaction is recorded in the functional currency of the recording entity using the exchange rate in effect at that date. Using the exchange rate at that date may not be practical therefore a weighted average rate may be used. Transaction gains or losses arise due to changes in the exchange rate among:

  • the transaction date and the settlement date;
  • the transaction date and a subsequent balance-sheet date; or
  • a subsequent balance-sheet date and the settlement date.

We will show some example entries to record a foreign exchange transaction, and for those examples here are some facts:

  • Company A is a US operating entity whose functional currency is the US dollar (USD),
  • Company B is a Spanish operating entity whose functional currency is the euro (EUR)
  • Company A purchased product from Company B on November 16, 2020
  • The transaction was denominated in EUR
  • The cost of the product is 50,000 EUR at the date of transaction
  • The exchange rate on November 16, 2020 was 1 EUR: 1.18326 USD.
  • Company A recorded a payable and related expense for 59,163 USD using the exchange rate on the date of the transaction
  • The exchange rates were as follows:
    • 1.8326 on November 16, 2020
    • 2.2389 on December 18, 2020
    • 2.2824 on December 31, 2020
    • 2.0748 on January 18, 2021

Example Entry #1

If settled before year end, for example on December 18, 2020 Company A would owe Company B 61,194 USD based on the exchange rate as of that date. Company A would make the following entry:

Accounts Payable                                               59,163

Foreign Exchange Loss  – Realized            2,031

Cash                                                  61,194

Example Entry #2

If settled after year end, Company A would adjust the payable at year end based on the exchange rate as of December 31, 2020, which amounts to 61,412 USD. When recording this adjustment, it is common for companies to have a contra account instead of adjusting the accounts payable balance. A common name would be Accounts Payable – Revaluation. Company A would make the following entry:

Foreign Exchange Loss  – Unrealized                                 2,249

Accounts Payable – Revaluation                  2,249

Example Entry #3

Once the payable is settled after year end on January 18, 2021, the amount owed based on the exchange rate at that time would be 60,374 USD. Company A would then make the following entry:

Accounts Payable                                                                            59,163

Accounts Payable – Revaluation                                              2,249

Foreign Exchange Loss – Realized                                          1,211

Cash                                                                              60,374

Foreign Exchange Gain – Unrealized            2,249

How are foreign currency transactions treated for tax purposes? It’s simple, you only recognize what is realized. A realized foreign exchange gain or loss is ultimately recorded when that transaction is settled, for example the cash receipt related to an account receivable was received or cash paid related to an outstanding payable. That would be either a realized gain recognized as ordinary income or a realized loss that would be fully deductible. Any unrealized gain or loss will be a temporary difference and will eventually reverse itself once the gain/loss is realized. The unrealized gain or loss would be related to any outstanding accounts receivable or accounts payable at year end denominated in a foreign currency that is revalued at year end using the year end exchange rate.

Example entry #1 records a Foreign Exchange Loss of 2,031 USD when the transaction settled, which was before year end, and would be a realized loss and be fully deductible on the Company A’s 2020 tax return.

Example entry #2 records a Foreign Exchange Loss of 2,249 USD as the transaction was not settled before year end and would be considered an unrealized exchange loss. This loss would not be deductible and be considered a temporary difference and therefore included in Company A’s deferred tax calculation.

Example entry #3 records an unrealized foreign exchange gain of 2,249 USD because the transaction settled after year end would not be a realized gain for tax purposes. The unrealized gain is a reversal of the unrealized loss recorded in example entry #2. The difference between the original accounts payable balance of 59,163 USD and the actual cash paid of 60,374 USD is the realized loss of 1,211 USD that is deductible on Company A’s 2021 tax return.

It is common for companies to record foreign exchange gain or losses to one account, but it is important to account for unrealized and realized gains and losses separately in the company’s books and records to ensure proper tax treatment. In the examples above, you can see there are separate accounts for the realized and unrealized amounts. This can ensure you are not recognizing too much income or taking too much expense on your tax return.

This article does not include accounting treatment related to foreign currency transactions related to derivative instruments.

Authors: Shannon Metz | smetz@withum.com, Angela Pulaski | apelaski@withum.com

Podcast Spotlight: Foreign Exchange Transactions

Listen in to our latest episode of Taxing Topics as Angela Pulaski and Shannon Metz have a discussion on what foreign exchange transactions are, how to properly account for them in a Company’s books and records, and how they impact a Company’s taxable income.

Don’t miss out on new episodes from Withum’s Taxing Topics podcast! Listen and subscribe on Google Podcasts or Spotify.

Contact our Withum’s International Tax Team to help address your further questions.

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