Foreign currency transactions

A foreign currency transaction is a transaction denominated in a currency other than an entity’s

functional currency. To include a foreign currency transaction in its financial statements, an entity must
measure it in its functional currency.

Both a reporting entity and its distinct and separable operations may enter into foreign currency
transactions. Foreign currency transactions of a distinct and separable operation should first be measured
in its functional currency and then, if the operation is a foreign entity, translated into the reporting
currency of its immediate parent. See FX 5 for information on financial statement translation and
remeasurement.

When there are foreign currency transactions between members of a consolidated group that result in
intercompany balances that are not considered to be of a long-term investment nature, the resulting
transaction gain or loss survives consolidation even though the balance sheet accounts eliminate in
consolidation.

Foreign currency transactions

Foreign currency transactions can be entered into by a reporting entity or its distinct and separable
operations. For example, a subsidiary of a reporting entity with a functional currency of the US dollar
may purchase inventory at a price denominated in euros, or a foreign entity with a Mexican peso
functional currency may sell products in US dollars; each of these is a foreign currency transaction.

Some commonly occurring foreign currency transactions include

 Revenue and accounts receivable arising from export sales

 Expenses and accounts payable arising from the purchases of imported goods and the payment of
wages in a foreign currency
 Intercompany transactions
 Investments in debt denominated in a foreign currency
 Foreign currency denominated loans from financial institutions
 Foreign bank accounts
 Taxes imposed by foreign tax jurisdictions

When identifying foreign currency transactions, only the functional currency of the party that entered
into the transaction should be considered; the functional currencies of the counterparty to the transaction
and the reporting entity are irrelevant.

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Initial measurement of foreign currency transactions
All foreign currency transactions should be initially measured and recorded in an entity’s functional
currency using the exchange rate on the date of the transaction.

Example 1, illustrates the initial measurement of a foreign currency transaction.

USA Corp is a US registrant with a US dollar (USD) functional currency.

On August 1, 20X1, USA Corp purchases office printers (capitalized assets) on account for 1,000 British
pound sterling (GBP). The exchange rate on August 1, 20X1 is USD 1.5 = GBP 1.

How does USA Corp measure and record this foreign currency transaction?

Analysis

Because the transaction is denominated in a currency other than the USA Corp’s functional currency, the
purchase of the printers is considered a foreign currency transaction. Accordingly, USA Corp should
measure and record the office printers and corresponding account payable in its functional currency, the
US dollar, using the exchange rate on the purchase date.

GBP 1,000 × (1.5/ 1) = USD 1,500

To record its purchase of office printers, USA Corp would record the following entry in US dollars:

Dr. Office printers USD 1,500

Cr. Accounts payable USD 1,500

Subsequent measurement of foreign currency transactions

The accounting for a foreign currency transaction after initial recognition depends on whether the asset
or liability created is considered monetary or nonmonetary.

Measurement of monetary and nonmonetary assets and liabilities

Determining whether an asset or liability is considered monetary or nonmonetary is the first step in
applying the measurement provisions in ASC 830.

The ASC Master Glossary defines foreign currency, monetary assets and liabilities, and nonmonetary
assets and liabilities.

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Monetary Assets and Liabilities: Monetary assets and liabilities are assets and liabilities whose
amounts are fixed in terms of units of currency by contract or otherwise. Examples are cash, short- or
long-term accounts and notes receivable in cash, and short- or long-term accounts and notes payable in
cash.

Nonmonetary Assets and Liabilities: Nonmonetary assets and liabilities are assets and liabilities other
than monetary ones. Examples are inventories; investments in common stocks; property, plant, and
equipment; and liabilities for rent collected in advance.

Foreign currency denominated monetary assets and liabilities are settled in the foreign currency at a
future date. Settlement of foreign currency denominated monetary assets and liabilities has a direct
impact on an entity’s functional currency cash flows (i.e., the amount of cash, in terms of the entity’s
functional currency, received or paid at settlement will vary with foreign currency exchange rates). By
their inherent nature, nonmonetary assets and liabilities do not result in future settlements in a foreign
currency. For example, once purchased, a fixed asset will only be depreciated or impaired. If the fixed
asset is later sold, the cash or accounts receivable received in exchange are considered monetary assets,
but that designation does not change the fixed asset’s nonmonetary nature.

When determining whether an asset or liability is monetary or nonmonetary, a reporting entity should
consider the guidance in ASC 830-10-45-18 and ASC 255, Changing Prices. While ASC 255 was not
specifically created to be applied to foreign currency transactions, the information is helpful in
distinguishing assets and liabilities as monetary or nonmonetary. ASC 255-10-20 also provides
definitions of monetary assets and liabilities while ASC 255-10-50-51 and 50-52 provide examples.

Monetary Assets: Money or a claim to receive a sum of money the amount of which is fixed or
determinable without reference to future prices of specific goods or services.

Monetary Liability: An obligation to pay a sum of money the amount of which is fixed or determinable
without reference to future prices of specific goods and services.

The economic significance of nonmonetary items depends heavily on the value of specific goods and
services. Nonmonetary assets include all of the following:

a. Goods held primarily for resale or assets held primarily for direct use in providing services for
the business of the entity.
b. Claims to cash in amounts dependent on future prices of specific goods or services.
c. Residual rights such as goodwill or equity interests

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ASC 255-10-50-52

Nonmonetary liabilities include both of the following:

a. Obligations to furnish goods or services in quantities that are fixed or determinable without
reference to changes in prices.
b. Obligations to pay cash in amounts dependent on future prices of specific goods or services.

Measurement of monetary assets and liabilities

Foreign currency denominated monetary assets and liabilities should be measured at the end of each
reporting period using the exchange rate at that date. The offsetting entry should generally be recorded
in the income statement as a foreign currency transaction gain or loss as discussed in ASC 830-20-35-1
and ASC 830-20-35-2.

Example FX 4-2 illustrates the subsequent measurement of a monetary liability.

EXAMPLE FX 4-2

Measurement and settlement of a monetary liability

USA Corp is a US registrant with a US dollar (USD) functional currency.

On August 1, 20X1, USA Corp purchases office printers (capitalized assets) on account for 1,000 British
pound sterling (GBP).

USA Corp issues quarterly financial statements on September 30, 20X1, and pays its GBP 1,000 account
payable to the counterparty on October 15, 20X1. The exchange rates are shown in the following table.

Date Exchange rate

August 1, 20X1 USD 1.5 = GBP 1

September 30, 20X1 USD 1.4 = GBP 1

October 15, 20X1 USD 1.3 = GBP 1

How should USA Corp measure and record this foreign currency transaction (a) in its quarterly financial
statements for the quarter ended on September 30, 20X1, and (b) upon settlement of its account payable
on October 15, 20X1?

Analysis

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The GBP denominated account payable is a monetary liability. To prepare its September 30, 20X1
financial statements, USA Corp must first measure the foreign currency account payable using the
exchange rate on that date.

GBP 1,000 × (1.4/ 1) = USD 1,400

USA Corp would then record an entry to recognize the difference between the US dollar balance on
September 30, 20X1, and the US dollar balance on August 1, 20X1 (USD 1,500), the date the initial
account payable was recognized. The offsetting entry is recorded in the income statement as a foreign
currency transaction gain.

Dr. Accounts payable USD 100

Cr. Foreign currency transaction gain USD 100

To record the settlement of its account payable with UK PLC on October 15, 20X1, USA Corp would
first measure its foreign currency account payable using the exchange rate on that date.

GBP 1,000 × (1.3/ 1) = USD 1,300

USA Corp would then record an entry to recognize the difference between the US dollar balance on
September 30, 20X1 (USD 1,400), the most recent reporting date, and the US dollar balance on October
15, 20X1. The offsetting entry is recorded in the income statement as a foreign currency transaction
gain.

Dr. Accounts payable USD 100

Cr. Foreign currency transaction gain USD 100

Finally, to record the payment of GBP 1,000 and relieve the account payable, USA Corp would record
the following entry.

GBP 1,000 × (1.3/ 1) = USD 1,300

Dr. Accounts payable USD 1,300

Cr. Cash USD 1,300

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Challenges and risk associated to foreign currency exchange
Several challenges and risks are associated with foreign currency transactions. For instance,

 Exchange Rate Fluctuations: The most significant risk in foreign currency transactions is the
volatility of exchange rates. Currency values can fluctuate rapidly due to various factors such as
economic conditions, geopolitical events, interest rate changes, or government policies. These
fluctuations can result in gains or losses when converting foreign currency transactions back into
the reporting currency.

 Transaction Exposure: Transaction exposure refers to the risk that the value of a foreign
currency transaction will change between the transaction date and the settlement date. This
exposure can lead to uncertainty in the final amount to be paid or received in the reporting
currency, impacting profitability and cash flows.

 Translation Risk: Translation risk arises when a company translates the financial statements of
its foreign subsidiaries or branches into the reporting currency. Exchange rate fluctuations can
significantly impact the translated amounts, resulting in translation gains or losses, which affect
the consolidated financial statements.

 Economic and Political Risks: Operating in foreign countries exposes companies to economic
and political risks unique to those jurisdictions. Economic risks include inflation, changes in
interest rates, and economic instability. Political risks can include changes in government
policies, regulations, taxation, or political instability. These factors can impact exchange rates
and the overall business environment.

 Hedging Challenges: Companies often use hedging instruments such as forward contracts,
options, or swaps to mitigate foreign currency risks. However, hedging introduces its own
challenges, including the effectiveness of hedging strategies, timing considerations, liquidity
constraints, and potential costs associated with hedging transactions.

 Complexity of Accounting and Reporting: Foreign currency transactions require companies to

navigate complex accounting and reporting requirements. Determining the appropriate exchange
rates, recognizing foreign exchange gains or losses, and properly disclosing the impact of foreign
currency transactions in financial statements can be challenging.

 Operational and Transactional Costs: Engaging in foreign currency transactions may involve
additional operational and transactional costs such as foreign exchange fees, transaction fees, or

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 costs associated with hedging instruments. These costs can impact profitability and need to be
carefully managed.

 Legal and Regulatory Compliance: Conducting business in foreign jurisdictions requires

compliance with local laws, regulations, and reporting requirements. Companies need to be
aware of foreign exchange controls, restrictions on currency conversion, and other regulatory
frameworks that may impact their foreign currency transactions.

To manage these challenges and risks effectively, companies engaging in foreign currency transactions
should develop robust risk management strategies, monitor exchange rate movements, implement
appropriate hedging mechanisms, stay informed about economic and political developments, and seek
expert advice when necessary. A thorough understanding of the risks and proactive risk management
practices can help mitigate the potential adverse impacts on financial performance and cash flows.

Translation of foreign Currency financial Statements

Translation of foreign currency financial statements is the process of converting the financial statements
of a foreign subsidiary or branch from its functional currency to the reporting currency of the parent
company or the entity preparing consolidated financial statements. This process is necessary when the
parent company or the reporting entity operates in multiple countries and needs to consolidate the
financial results of its subsidiaries.

Steps of the translation process

I. Determining the Functional Currency

The functional currency is the primary currency in which the subsidiary operates and generates cash
flows. It is typically the currency of the country where the subsidiary is located. The functional
currency is determined based on various factors, including the economic environment, currency
restrictions, cash flows, and management's judgment.

II. Selection of Translation Method

There are two main methods for translating foreign currency financial statements:

a. Current Rate Method: Under this method, all assets and liabilities are translated at the
exchange rate in effect at the balance sheet date (closing rate), while income and
expenses are translated at the average exchange rates for the period or an appropriate
approximation. The resulting translation adjustments are recorded in a separate
component of equity.

b. Temporal Method: This method is used when the functional currency of the foreign
subsidiary is different from its reporting currency, and the subsidiary's activities are
subject to significant fluctuations in exchange rates. The temporal method involves
translating monetary assets and liabilities at the current exchange rate, while non-

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 monetary assets and liabilities are translated at historical exchange rates. Income and
expenses are translated at exchange rates approximating the date of the transaction. The
resulting translation adjustments are recorded in the income statement.

III. Translation at the Closing Rate

Using the selected translation method, the financial statements of the foreign subsidiary are
translated into the reporting currency. The balance sheet items such as assets, liabilities, and equity
are translated at the closing rate, while income statement items such as revenues, expenses, gains,
and losses are translated at the average exchange rates for the period or an appropriate
approximation.

IV. Calculation of Translation Adjustments

The difference between the translated amounts and the historical exchange rates is recognized as a
translation adjustment in a separate component of equity. This adjustment reflects the impact of
exchange rate fluctuations on the consolidated financial statements.

V. Consolidation

Once the financial statements of the foreign subsidiary are translated into the reporting currency,
they are consolidated with the parent company's financial statements to prepare the consolidated
financial statements. The consolidation process involves eliminating intercompany transactions,
balances, and unrealized gains or losses arising from the translation adjustment.

The translation of foreign currency financial statements does not impact the cash flows or the underlying
economic value of the foreign subsidiary. It primarily reflects the changes in exchange rates between the
functional currency and the reporting currency.

Companies conducting business globally and preparing consolidated financial statements need to
understand the applicable accounting standards, exchange rate fluctuations, and their potential impact on
financial reporting. Seeking professional advice and adhering to relevant accounting principles ensure
accurate and transparent financial reporting in such scenarios.