Foreign currency exchange can have a significant impact on revenue and M&A transactions. This article explains how Burkland’s accounting team handles the complexities of foreign exchange transactions.
Foreign Exchange Effects on Profit and Loss
A transactional foreign exchange gain or loss arises when a transaction is recorded in a company’s accounts at the exchange rate at the time of the transaction, but payment is made at a different rate. Foreign exchange accounting standards require the transaction to be initially recorded with the exchange rate at the transaction date and the exchange rate gains/losses to be presented as other income or expense in the profit and loss account.
For example, You receive an invoice from an international consultant, dated Nov 5, 2021, for an expense of 5,000 Euros. The exchange rate on the transaction date was 1.2; hence, the liability and expense are booked at $6,000. You have a 15-day term, so you pay the invoice on Nov 20, 2021, but the exchange rate now is 1.25. Hence, the liability is taken off the books at $6,000 with the bank reduced by $6,250 (5000 euros x 1.25). The remaining $250 is the exchange loss on the transaction. This should be shown as “Other income or expense” in the profit and loss account.
Foreign Exchange Effects on Consolidations
What are the steps to translate foreign currency during consolidation and account for it under GAAP?
Identify the subsidiary’s recording and functional currencies:
- Reporting Currency – currency in which an entity’s consolidated financial statements or other financial documents are to be reported.
- Recording Currency – currency in which the subsidiary’s books and records are maintained.
- Functional Currency – currency of the economic environment in which the entity generates and expends cash. An entity can be any form of operation, including a subsidiary, division, branch, or joint venture.
When the subsidiary is heavily integrated with the parent company, and it serves as a sales outlet for the parent, the subsidiary’s functional currency is the parent’s reporting currency. However, if the subsidiary is relatively self-contained and independently operates primarily in local markets, then the local currency is its functional currency.
To determine the functional currency of an entity’s foreign operations, consider the following factors:
- Subsidiary’s operations are essentially an extension of the reporting entity.
- Subsidiary’s transactions with the reporting entity constitute a high proportion of the operation’s activities
- Cash flows from the Subsidiary directly affect the cash flows of the reporting entity and are available for remittance
- Subsidiary’s cash flows cannot service its debt obligations without funds transfers from the reporting entity
In all of the above, the functional currency of the Subsidiary is the currency of the reporting entity.
- Subsidiary can operate with a significant degree of autonomy
- Subsidiary’s transactions with the reporting entity constitute a low proportion of the operation’s activities
- Cash flows from the Subsidiary do not directly affect the cash flows of the reporting entity and are not available for remittance
- Subsidiary’s cash flows can service its debt obligations without funds transfers from the reporting entity
In all of the above, the functional currency of the Subsidiary is its local currency.
Translation Process
If the subsidiary’s functional and reporting currencies are the same, remeasure from the recording currency to the functional currency. If the subsidiary’s functional and recording currencies are the same, translate from functional currency to the reporting currency.
If your startup is struggling with global impacts on your accounting and finances, Burkland’s team of startup accounting experts is here to help.