Foreign currency accounting is a challenge for businesses with foreign suppliers, partnerships, and operations unless they use specialized software designed for handling FX cross-border payments. Advanced FX accounting software includes automation features for increased efficiency, security, and currency fluctuation / foreign exchange risk reduction.
Understand the framework of FX accounting and how it differs from domestic transaction accounting and financial statement reporting. Learn best practices for optimizing your FX accounting processes.
What is Foreign Exchange (FX) Accounting?
FX accounting for foreign exchange involves recording transactions conducted in other than the functional currency and adjusting them for changes in foreign exchange rates. FX accounting includes the translation of foreign entity financial statements into their parent company’s functional currency during consolidation.
How Does FX Accounting Work?
The Financial Accounting Standards Board (FASB) includes generally accepted accounting principles for accounting for foreign exchange in its Accounting Standards Codification as ASC 830, “Foreign Currency Matters.” FX accounting for a forward contract is covered in the FASB’s ASC 815, “Derivatives and Hedging.” For more details on how GAAP foreign exchange accounting works, refer to these accounting standards.
Regarding foreign exchange gains and losses accounting treatment, the Shareholders’ Equity section of the balance sheet includes a category called Other Comprehensive Income. Other comprehensive income (OCI) includes unrealized gains and losses on foreign currency translation and transactions that are still pending before completion or liquidation. Upon completion of a transaction, gains and losses are recognized on the income statement and removed from inclusion in Other comprehensive income on the balance sheet.
GAAP accounting also requires disclosures for foreign currency accounting in the Notes to Financial Statements.
Foreign exchange accounting includes these GAAP applications:
- Functional currency of an entity
- Recording FX transactions
- Financial statements currency translation
- Recording and adjusting Other Comprehensive Income (OCI)
- Entering into and recording forward contracts for hedging FX
Besides GAAP, IFRS (International Financial Reporting Standards) provide rules for how to account for foreign exchange. For example, IAS 21, issued by the IFRS, is an international accounting standard, “The Effects of Changes in Foreign Exchange Rates.”
Functional Currency of an Entity
The first step in foreign exchange accounting is to determine an entity’s functional currency. Before codification in ASC 830, FASB Statement No. 52 (issued in December 1981) covered the foreign exchange accounting rules, including the definition of functional currency. The functional currency of a reporting entity and each of its international business entities are generally different.
According to the FASB summary of Statement 52:
“An entity’s functional currency is the currency of the primary economic environment in which that entity operates. The functional currency can be the dollar or a foreign currency depending on the facts. Normally, it will be the currency of the economic environment in which cash is generated and expended by the entity. An entity can be any form of operation, including a subsidiary, division, branch, or joint venture. The Statement provides guidance for this key determination in which management’s judgment is essential in assessing the facts.
A currency in a highly inflationary environment (3-year inflation rate of approximately 100 percent or more) is not considered stable enough to serve as a functional currency and the more stable currency of the reporting parent is to be used instead.”
Recording FX Transactions
Accounting for foreign currency transactions requires recording dates on the transaction recognition date and upon the payment and completion of the transaction at a later date.
FX transactions are initially recorded as of the recognition date at the current exchange rate for that transaction date (or the next available exchange rate if none is available for that date). A purchase transaction includes recording the expense or asset purchased and the related accounts payable liability. A sales transaction includes recording the revenue and the accounts receivable.
Because cash receipts and payments will occur later for sales and purchases with trade credit terms, the foreign exchange rate will change between the purchase date and the date of customer collection or supplier payment.
Over time, transaction gains and losses need to be recorded for any changes between the functional currency and the foreign currency rate for each transaction. And the accounts receivable and accounts payable balances from these double-entry bookkeeping transactions will be adjusted in the general ledger accounts and on the balance sheet over time for these expected FX changes.
Before FX transactions are completed and realized in your business, foreign exchange unrealized gains and losses are included in the Shareholders’ Equity account on the balance sheet called Other Comprehensive Income (OCI). Upon realization of these FX gains and losses, the amounts are recorded in income statement accounts and removed from the OCI balance via journal entry.
Financial Statements Currency Translation
Financial statements currency translation is presenting the financial statement balances of its foreign entity’s functional currency financial statements in the parent’s reporting currency. The translation of a balance sheet is made using the current exchange rate at the end date of the financial reporting period (the balance sheet date). The translation of an income statement is at the average exchange rate for the reporting period.
Accountants translate foreign subsidiary/entity financial statements to the current exchange rate in the reporting currency at each accounting close date, making (CTA) cumulative translation adjustments (net of tax) in the Accumulated Other Comprehensive Income section in Shareholders’ Equity on the balance sheet.
Forward Contract for Hedging FX
A forward contract (forward foreign exchange contract or FEC) is a type of derivative instrument agreement made through a bank or foreign exchange service. A forward contract is used to hedge and protect against significant changes from currency fluctuations over time in foreign exchange. The FEC changes uncertainty in FX rate fluctuations to a locked-in certain future amount for a business.
In some countries with volatile economies, the currency fluctuation risks for FX can be extremely significant, increasing the case for FX hedging with forward contracts.
In a forward contract, the buyer takes a long position to buy a certain amount of foreign currency at a specified future date. The counterparty seller in the contract agrees to buy the same foreign currency on the same date, taking a short position.
The CPA Journal’s article, “Hedges of Recognized Foreign Currency-Denominated Assets and Liabilities,” explains the application of ASU-2017-12 and its relation to ASC 815, and ASC 830:
“Accounting Standards Codification (ASC) Topic 830, “Foreign Currency Matters,” requires companies to measure assets and liabilities denominated in a foreign currency at their dollar equivalent using the current spot rate. Exchange risk is the change in the dollar value of exposed assets or liabilities resulting from changes in the spot rate during a given period; these gains and losses are recognized and reported in earnings.
One method of managing the exposure to the exchange risk of an asset or liability denominated in a foreign currency is to enter into a foreign exchange forward contract to lock in the dollar amount of the transaction at maturity. Management can designate the forward contract as either a fair value or cash flow hedge of the foreign currency–denominated asset or liability because changes in spot rates affect both its fair value and its cash flows.
ASC Topic 815, “Derivatives and Hedging,” requires companies to measure foreign currency forward contracts at fair value, derived by discounting the difference between the contract rate and the current forward rate to the settlement date. The total gain or loss on the forward contract has two components. The first corresponds to the change in the forward contract resulting from changes in the spot rate and offsets the overall gain or loss on the underlying asset or liability. The second is the initial premium or discount on the forward contract; that is, the net gain or loss equals the initial premium or discount. The accounting for the two components is based on management’s forward contract hedge designation.”
Accounting for forward contracts is complex. Wikihow’s detailed article, “How to Account and Negotiate Forward Contracts,” presents FX accounting for forward contracts from the viewpoint of both the buyer and the seller.
Major CPA firms prepare and issue reliable and comprehensive publications on FX topics that you can also read.
Foreign Exchange Accounting vs. Traditional Domestic Accounting
Foreign exchange accounting adds steps to traditional domestic accounting. With FX accounting, you must record transactions in another currency at the exchange rate in effect at the time of the transaction or immediately afterward if an exchange rate isn’t available for that specific date. Then adjust for changes in the foreign exchange rate at later measurement dates before the transaction closes and is paid. And translate subsidiary financial statements into the parent’s functional currency whenever preparing a consolidated financial statement for the business.
When your business sources goods and services domestically, traditional accounting applies. Accounting can skip these steps for recording and adjusting transactions. If your business is single-entity or only has domestic business units, FX translation won’t apply to the company’s financial statements.
Example of Foreign Exchange Accounting
C Company, using the USD (U.S. dollar) as its functional currency, purchases inventory from J Corp, a supplier in the United Kingdom on May 12, 2023. The transaction is invoiced by J Corp in GBP (British pound sterling). C Company, the buyer, records its transaction in dollars at the current exchange rate on the shipment date of May 15, 2023, which is the invoice date.
The invoice amount is 3,000 GBP. Invoice terms are net 30.
On the invoice date, the conversion exchange rate is 1 GPB = 1.25 USD.
Invoice amount 3,000 GPB x 1.25 = $3,750 USD.
C Corp’s May 15, 2023 transaction to record the supplier invoice in U.S. dollars:
On June 14, 2023, C Corp pays the invoice. On that date, the currency exchange rate is 1 GPB = 1.27 USD.
C Corp’s June 14, 2023 transaction to pay the unhedged supplier invoice:
|Foreign Currency Exchange Loss
In this example, C Corp incurred a foreign currency exchange loss for an FX transaction from the increase in the exchange rate for GPB/USD from 1.25 to 1.27 between the vendor invoice date and their payment date. C Corp is paying more than expected for the inventory purchase due to unfavorable FX currency fluctuation. Therefore, C Corp’s net profitability will be lower or its net loss will be higher.
Foreign Exchange Accounting Best Practices
6 best practices for foreign exchange accounting are:
- Training: Adequately train your accountants responsible for preparing and approving FX transactions and global financial statements. Ensure that these financial accountants and managers complete continuing professional education courses covering the topic.
- Accounting standards and rules: Follow GAAP accounting standards and SEC requirements if they apply to your U.S.-based company operating globally or paying overseas suppliers and independent contractors and receiving international revenue in other currencies.
- U.S. dollar (USD) invoicing: Decide whether to require customer payments in U.S. dollars to eliminate foreign currency risk.
- Forward contracts: Consider using and accounting for forward contracts to hedge foreign exchange risk. You may have other choices like using forward options.
- FX software: Use the best FX and accounting software tools available for recording transactions, translating financial statements, and managing foreign currencies.
- View and understand your global cash flows in real-time.
How can your business improve foreign exchange accounting?
Download our white paper, “How to Eliminate Currency and Forex Challenges in Payables” to learn how your global business can optimize its FX accounting for accounts payable.
Add advanced FX automation software solutions, Multi-FX and FX Hedging, to AP automation software to achieve easier FX and currency management, protecting your company against foreign currency fluctuation risks.
Automate FX Accounting for Streamlined & Secure Processes
Based on a survey conducted by Tipalti, 89% of businesses solely rely on their payables team to manage cross-border foreign exchange processes.
But FX accounting is traditionally time-consuming, inefficient, and costly. When you can streamline your business FX processes, make them more secure, and reduce errors and fraud risk, FX accounting automation makes sense. Best practices for CFOs and treasurers indicate that manual FX processes should be replaced with FX automation. Successful businesses need currency management strategies.
How to Choose an FX Accounting Automation Solution
To choose an FX accounting automation solution, your business should assess how the FX solution will help it streamline and manage its multi-entity global businesses. Considerations include handling cross-border FX payment transactions, intercompany transfers, currency management strategies, and international accounts payable through one unified system.
Features and Benefits of FX and AP Automation Solutions
Tipalti FX and AP automation solutions let you plan, view, and better manage your international and domestic cash flows.
Tipalti’s AP automation and advanced FX solutions efficiently prepare a real-time payment reconciliation for large batch payments using multiple payment methods and different currencies. The automated payment reconciliation could help your company speed up its accounting close by 25%.
AP automation reduces end-to-end payables processing time by 80% and reduces errors by 66%. End-to-end payables processing begins with a self-service supplier portal for onboarding, electronic document management, and communications. The concept of end-to-end payables spans the entire invoice-to-pay workflow cycle for invoice processing.
With a volume of cross-border payments, your company needs FX software solutions to make global remittances less risky and more efficient. Financial management needs to avoid the disruption of making these global remittances manually. You’ll have the added benefit of choosing from multiple cost-effective, country-available payment methods instead of always relying on expensive international wire transfers.
FX and Currency Challenges and Solutions
Will the FX automation system reduce or eliminate the need to:
- Convert currencies to fund each entity’s foreign operations in local currency
- Pay high spot rates for foreign exchange
- Work with several regional international banks to hold their foreign bank accounts
- Risk non-compliance with global regulations
- Experience unfavorable financial impacts from foreign currency fluctuations for supplier payments due later
- Divert financial management time and focus from more valuable strategic finance work?
Tipalti Multi-FX and Tipalti FX Hedging software automation products used with Tipalti AP automation software for invoice processing and payments provide a solution to overcome these FX challenges and time wasters.
The following white paper lists specific questions to help determine when a business needs to add efficient FX automation functionality for AP. For ways to improve your company’s FX accounting, download “How to Eliminate Currency and Forex Challenges in Payables.”