How to Account for Foreign Currency Transactions: Journal Entries and Examples

What Is a Foreign Currency Transaction?

A foreign currency transaction is a purchase, sale, loan, or borrowing denominated in a currency other than the company’s functional currency. Under US GAAP (ASC 830), record it at the spot rate on the transaction date, update the receivable or payable to the current rate at each balance sheet date, and report exchange gains or losses in net income.

The functional currency is the currency of the primary economic environment in which an entity operates; it is determined from economic indicators, rather than the entity’s location alone. The denominated currency is the currency specified in the invoice or loan agreement. The examples below assume that the US company’s functional currency is the US dollar. IFRS (IAS 21) follows the same basic transaction-accounting sequence, using terms such as “closing rate” and “profit or loss.”

Why does this matter? Exchange rates move between the day you book a deal and the day cash changes hands, and that movement creates a gain or loss. Below you’ll find the key terms, the journal entries, two worked examples, a practice question, and the exam traps students miss most.

Key Concepts

• Functional Currency: The currency of the primary economic environment in which the entity operates.
• Reporting Currency: The currency in which the financial statements are presented.
• Exchange Rate: The price of one currency in terms of another currency.
• Foreign Currency Transaction Gain or Loss: The gain or loss caused by exchange rate changes between the transaction date and the settlement date. If a balance sheet date falls in between, part of the gain or loss is recognized at that date and the rest at settlement.
• Denominated Currency: The currency a transaction is written in, such as the currency on the invoice or loan agreement. If it differs from your functional currency, you have a foreign currency transaction.
• Spot Rate: The exchange rate for immediate delivery of a currency on a given date.
• Monetary Items: Cash, plus amounts you will receive or pay in a fixed number of currency units, such as receivables, payables, and loans. These are updated to the current rate at each balance sheet date.
• Nonmonetary Items: Items such as inventory, equipment, and prepaid expenses. When carried at historical cost, they stay at the exchange rate on the transaction date.
• How Rates Are Quoted: This article quotes rates as US dollars per one unit of foreign currency. For example, 1.10 USD/EUR means €1 costs $1.10, so you multiply the euro amount by 1.10. If a problem quotes the rate the other way (euros per dollar), divide instead.

Exam Trap: Who Has the Foreign Currency Transaction?

Only the company whose functional currency differs from the invoice currency has a foreign currency transaction. Assume a US company with the US dollar as its functional currency buys goods from a German supplier whose functional currency is the euro.

If the invoice is in US dollars, the US company records a normal purchase in dollars. There is no exchange gain or loss for the US company. The German supplier carries the exchange rate risk.

If the invoice is in euros, the US company has the foreign currency transaction and records any exchange gain or loss.

Before calculating an exchange gain or loss, compare the invoice currency with each entity’s functional currency.

How Do You Account for Foreign Currency Transactions?

The accounting for foreign currency transactions involves several steps, which include initial recognition, subsequent measurement, and the recognition of any foreign exchange gains or losses.

1. Initial Recognition: Foreign currency transactions should be recorded in the entity’s functional currency by applying the spot exchange rate between the functional currency and the foreign currency at the transaction’s date.
2. Subsequent Measurement:
   • On each reporting date, foreign currency monetary items (such as cash, receivables, and payables) should be reported using the closing rate, which is the spot exchange rate on the balance sheet date.
   • Non-monetary items (like inventory and fixed assets) carried at historical cost should be reported using the exchange rate at the transaction’s date.
   • Non-monetary items carried at fair value should be reported at the rate when the fair values were determined (this is the IAS 21 wording).
3. Recognition of Foreign Exchange Gains and Losses: Exchange gains and losses from settling these transactions, or from updating monetary items to the year-end rate, are included in net income (called profit or loss under IFRS) in the period they arise. Special rules apply to qualifying transactions. For example, in consolidated financial statements, exchange differences on intercompany balances of a long-term investment nature are included in the translation adjustment when settlement is not planned or anticipated in the foreseeable future. Long maturity alone does not qualify a loan for this treatment. Qualifying net investment hedges also have special OCI treatment; hedge accounting is outside this article’s scope.

Journal Entries for Foreign Currency Transactions

For an ordinary credit purchase or sale, measure the transaction in the entity’s functional currency at the transaction-date spot rate. The entries below assume that revenue recognition requirements have been met; the related cost-of-goods-sold entry is omitted.

At each reporting date: calculate the current functional-currency value of the foreign currency receivable or payable. Compare it with the recorded balance and recognize the difference as an exchange gain or loss. The direction depends on whether the item is an asset or a liability, as summarized below.

At settlement: remove the receivable or payable at its latest carrying amount, record cash at the settlement-date rate, and recognize the remaining difference as an exchange gain or loss. The two worked examples provide complete numerical entries.

Gain or Loss? A Quick Rule

When the rate is quoted as dollars per one unit of foreign currency (like 1.10 USD/EUR), use this table:

What you have	Foreign currency strengthens (rate goes up)	Foreign currency weakens (rate goes down)
Payable (you owe foreign currency)	Loss	Gain
Receivable (you are owed foreign currency)	Gain	Loss

Memory hook: if you owe a foreign currency and it gets more expensive, you lose. If you are owed a foreign currency and it gets more expensive, you win.

Video Example: Foreign Currency Payable

In this segment, Professor Farhat follows a foreign currency payable from the initial purchase through the reporting-date adjustment and final settlement, explaining how exchange-rate changes create gains and losses.

Selected segment: 23:28–30:18 from “Foreign Currency Transactions: Gains, Losses & Journal Entries.” Watch the complete lesson on YouTube.

For further study of foreign currency accounting, explore the Farhat Lectures Advanced Accounting course.

How Do Foreign Currency Transactions Affect the Financial Statements?

Foreign currency transactions impact financial statements as follows:

• Balance Sheet: Monetary assets and liabilities denominated in a foreign currency, such as cash, receivables, payables, and loans, are updated to the closing rate. Nonmonetary items carried at historical cost, such as inventory and equipment, stay at the exchange rate on the transaction date.
• Income Statement: Foreign exchange gains or losses, as a result of settling transactions or translating monetary items at the reporting date, are recognized in the income statement, impacting net income.
• Cash Flow Statement: Foreign currency cash flows are first measured in the entity’s functional currency using the exchange rate on the cash-flow date; an appropriate average rate may be used when it reasonably approximates actual rates. If the financial statements use a different reporting currency, the cash flows must also be translated into that reporting currency. The effect of exchange rate changes on foreign currency cash and cash equivalents is presented separately from operating, investing, and financing cash flows to reconcile beginning and ending balances.

What Must Companies Disclose?

Under US GAAP, ASC 830-20-45-1 requires companies to disclose the aggregate (total) transaction gain or loss included in net income for the period. Under IFRS, IAS 21 requires disclosure of the exchange differences recognized in profit or loss, except those arising on financial instruments measured at fair value through profit or loss. Additionally, disclosures about the entity’s foreign currency exposure and its management of foreign exchange risk are essential for providing users of financial statements with a complete understanding of the entity’s financial position and risk management strategies.

Worked Example 1: Buying Inventory for €10,000 on Credit

Let’s consider a company based in the US (functional currency USD) that purchases goods from a European supplier for €10,000 on credit when the exchange rate is 1.10 USD/EUR.

Step 1: Record the Purchase

This entry records the initial purchase of inventory at the current exchange rate.

Step 2: Adjust at Year-End

Assume that by the end of the financial period, when the company prepares its financial statements, the exchange rate has changed to 1.15 USD/EUR. The company has not yet paid the supplier.

This entry increases accounts payable to the year-end rate (€10,000 x 1.15 USD/EUR = $11,500). You now owe $500 more than you originally recorded, so the $500 is a foreign exchange loss.

Step 3: Pay the Supplier

Finally, assume the company pays off the liability when the exchange rate is 1.20 USD/EUR.

This entry records the payment of the accounts payable at the current exchange rate, including the additional loss due to the further change in the exchange rate since the last adjustment.

How Example 1 Shows Up in the Financial Statements

1. Balance Sheet:
   • Assuming the inventory remains on hand and no other valuation adjustment is required, its historical cost remains $11,000. Subsequent exchange rate changes on the payable do not change that historical cost. Accounts payable, a monetary item, is reported at $11,500 on the year-end balance sheet, and the $500 loss reduces retained earnings through net income.
2. Income Statement:
   • The total foreign exchange loss is $1,000 ($12,000 paid minus $11,000 originally recorded). Because the payment happens after year-end, the loss is split: $500 in the year of purchase (the year-end adjustment) and $500 in the year of payment. US GAAP does not dictate the income statement line, so many companies report it in other income (expense) while some include it in operating income. Either way, the total transaction gain or loss for the period must be disclosed.
3. Cash Flow Statement:
   • The payment of the liability will be shown under cash flows from operating activities as an outflow of $12,000.

This example demonstrates how foreign currency transactions are recorded at the transaction date and adjusted for exchange rate changes at the reporting date, with the impacts reflected in the financial statements.

Worked Example 2: A Receivable That Swings From Gain to Loss

Now let’s flip it. A US company (functional currency USD) sells goods to a customer in France for €20,000 on account on November 15, Year 1, when the rate is 1.08 USD/EUR. On December 31, Year 1, the rate is 1.12. The customer pays on January 20, Year 2, when the rate is 1.05.

Step 1: Record the Sale (November 15, Year 1)

Step 2: Adjust at Year-End (December 31, Year 1)

The receivable is now worth €20,000 x 1.12 = $22,400, which is $800 more than recorded. The euro got stronger and you are owed euros, so that’s a gain.

Step 3: Collect the Cash (January 20, Year 2)

You receive €20,000 x 1.05 = $21,000, but the receivable is carried at $22,400.

The result: Year 1 reports an $800 gain and Year 2 reports a $1,400 loss. Over the life of the receivable, the company has a net $600 loss ($21,000 collected minus $21,600 originally recorded). Sales revenue remains $21,600 in this example. Subsequent exchange rate changes on the receivable are recognized separately as exchange gains or losses rather than adjustments to the original sales revenue.

Practice Question

Try this before you check the answer. A US company whose functional currency is the US dollar buys inventory for £50,000 on account when the rate is $1.30 per pound. At year-end, the rate is $1.34. The company pays the supplier the following year when the rate is $1.32. What exchange gain or loss does the company report in each year?

Answer: In Year 1, the payable grows from $65,000 (£50,000 x 1.30) to $67,000 (£50,000 x 1.34), so the company reports a $2,000 loss. In Year 2, it pays $66,000 (£50,000 x 1.32) to settle a $67,000 payable, so it reports a $1,000 gain. The net effect is a $1,000 loss, and the inventory’s historical cost remains $65,000; subsequent exchange rate changes on the payable do not change that cost.

Common Mistakes Students Make

1. Adjusting the historical cost of inventory or equipment for subsequent exchange rate changes. In these examples, remeasure the foreign currency monetary balance; retain the asset’s transaction-date historical cost.
2. Booking the whole gain or loss in one year. If a balance sheet date falls between the purchase and the payment, split it between the two periods.
3. Getting the direction backwards. If you owe euros and the euro gets stronger, you lose.
4. Treating a dollar invoice as a foreign currency transaction. If the invoice is in your functional currency, there is no exchange gain or loss for you.
5. Mixing up transaction gains and losses with translation adjustments. Transaction gains and losses go to net income. Translation adjustments from consolidating a foreign subsidiary go to other comprehensive income.

Key Takeaways

• A foreign currency transaction is denominated in a currency other than your functional currency.
• Record it at the spot rate on the transaction date.
• At each balance sheet date, update monetary items (cash, receivables, payables, and loans) to the current rate. For inventory and equipment carried at historical cost, retain the transaction-date rate.
• Exchange gains and losses on these transactions go to net income, with a few exceptions that go to other comprehensive income.
• When a transaction spans two reporting periods, each period reports its own piece of the gain or loss.
• Exam tip: when a question gives you a transaction date, a year-end date, and a settlement date, calculate the gain or loss for each period separately before you look at the answer choices.

Want more practice? Watch the full foreign currency lessons in the Advanced Accounting course, or try the Free Sample Course to see how Farhat Lectures explains tough topics step by step.

Frequently Asked Questions About Foreign Currency Transactions

1. What is a foreign currency transaction?

It is a transaction denominated in a currency other than the entity’s functional currency, such as a credit sale, credit purchase, loan, or borrowing.

2. How are foreign currency transactions recorded in financial statements?

Foreign currency transactions are initially recorded at the spot exchange rate on the transaction’s date. At each reporting date after that, foreign currency monetary items (cash, receivables, payables, and loans) are updated to the closing rate, which is the spot rate on the balance sheet date. Nonmonetary items carried at historical cost, such as inventory and equipment, are not adjusted. The resulting exchange differences are recognized in net income (called profit or loss under IFRS).

3. What is the functional currency, and how is it determined?

The functional currency is the currency of the primary economic environment in which the entity operates, usually the currency it mainly earns and spends cash in. Under US GAAP (ASC 830), management weighs indicators such as cash flows, sales prices, the sales market, expenses, financing, and intercompany transactions. Under IFRS (IAS 21), the main factors are the currency that mainly influences sales prices (including the country whose competitive forces and regulations set those prices) and the currency that mainly influences labor, material, and other costs.

4. What is the difference between a foreign currency transaction gain or loss and a translation adjustment?

A foreign currency transaction gain or loss comes from exchange rate changes on receivables, payables, and other monetary items denominated in a foreign currency, measured from the transaction date (or the last balance sheet date) to the settlement date (or the current balance sheet date). Translation adjustments arise when financial statements of a foreign operation are translated into the presentation currency of the reporting entity (called the reporting currency under US GAAP). Transaction gains or losses affect net income, while translation adjustments are included in other comprehensive income.

5. How do exchange rates affect foreign currency transactions?

A stronger foreign currency increases the functional-currency value of both a receivable and a payable. That creates a gain on the receivable and a loss on the payable. A weaker foreign currency reverses those effects.

6. Can foreign currency transaction losses be avoided?

While it’s not always possible to completely avoid foreign currency transaction losses due to the fluctuating nature of exchange rates, businesses can use hedging strategies to mitigate risk. Forward contracts and futures contracts lock in an exchange rate for a future date. Currency options protect against unfavorable moves while still letting the company benefit from favorable ones, in exchange for an upfront premium. A simpler approach is to invoice in your own functional currency, which shifts the exchange rate risk to the other party.

7. Do You Adjust Inventory or Equipment When Exchange Rates Change?

No. Inventory, equipment, and other nonmonetary items carried at historical cost stay at the exchange rate on the date you bought them. Only monetary items, such as cash, receivables, payables, and loans, are updated to the current rate. In Worked Example 1, inventory stays at $11,000 even though the payable rises to $11,500.

8. Who Records the Gain or Loss When an Invoice Is in US Dollars?

Compare the invoice currency with each company’s functional currency. If the US buyer’s functional currency is the US dollar and the German supplier’s is the euro, a dollar-denominated invoice creates foreign currency exposure for the supplier, but not for the buyer. If both companies use the dollar as their functional currency, neither has a foreign currency transaction from that invoice.

Sources and Further Reading

• Deloitte DART, Roadmap: Foreign Currency Transactions and Translations, Chapter 4 (ASC 830-20): Foreign Currency Transactions
• IAS Plus summary of IAS 21, The Effects of Changes in Foreign Exchange Rates: IAS 21 overview

About the Author

Mansour Farhat, CPA, CIA, DBA, is a veteran accounting educator and the founder of Farhat Lectures and its YouTube channel. He holds a Doctor of Business Administration from Temple University and a Master of Accountancy from Bloomsburg University. He helps accounting students and CPA, CMA, and EA candidates understand the reasoning behind the answers, one step at a time. Learn more about Professor Farhat.