How to account for foreign currency transactions
Foreign currency transactions
A foreign currency transaction is one that requires settlement, either payment or receipt, in a foreign currency. When the exchange rate changes between the original purchase or sale transaction date and the settlement date, there is a gain or loss on the exchange. Whoever views the denominated currency (the currency the transaction takes place in) as the foreign currency takes the gain or loss. So, if your usual currency is sterling and you invoice a customer in dollars, you will need to reflect any exchange gain or loss in your accounts.
Tip. Where possible, insist on billing and being paid in sterling so the foreign exchange (forex) risk is passed to your customer.
Tip. The risk of an adverse forex movement is higher the greater the sums involved and the longer the time between invoice and settlement dates. Don’t accumulate sales over time on to one large consolidated foreign currency invoice for overseas customers. Invoice more frequently in smaller amounts.
Tip. Insist on shorter credit periods with overseas customers to reduce the time you are exposed to foreign currency movements between billing and settlement date. Include a penalty clause enabling you to claw back foreign exchange movements on late payments.
Tip. If you make many foreign currency transactions, consider buying a forward currency contract to get a guaranteed rate.
Recording the value of the transaction
Record the value of the transaction in dollars at the exchange rate current at the time of purchase or sale.
Example. A US company buys goods from a UK company for $14,000. The exchange rate at that date is $1.40 to £1 so you would post the sales invoice as £10,000. The US company pays you $14,000 dollars two months later when the exchange rate has moved to $1.45 to £1. You would then need to record the receipt as £9,655 (£14,000/1.45) and write off the difference to an exchange rate gain/loss account in your P&L account. Tip. If you’re invoicing in a foreign currency and you’re registered for UK VAT, you also need to show the sterling equivalent of the total amount of VAT, if any, of what you’re selling.
At the year-end date
When it comes to your year end, any foreign currency trade debtors (or creditors) will need to be revalued to the exchange rate at the year-end date.
Example. At the year-end date, the exchange rate is $1.5 to £1. The US company still owes $14,000 at that date. Therefore, the amount relating to the US debtor at that date should be shown as £9,333 ($14,000/1.5) and the difference between the original sterling value (£10,000 in our example) and the £9,333 will need to be shown as a foreign exchange loss in the P&L account. Tip. You can use any published exchange rate, such as those found on xe.com or oanda.com in your accounts, rather than the “official” one set by international banks.
For a foreign exchange risk calculator, visit https://www.tips-and-advice.co.uk , Download Zone, year 14, issue 01.
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