For instance, if you think that the euro will have increased value, you; won’t simply purchase euros. You will need to look out for other currencies against which you consider that euros appreciate well. Thus, you can purchase EUR/USD, which can effectively be said as a bet that the euro appreciates well in values against the U.S. dollar. People exchange currency every single day, in real life or business.
What is Gain/Loss in Foreign Exchange?
Before moving on straight to calculate forex gain or loss, we must firmly understand Gain/Loss in Forex. When someone sells any form of services and goods in foreign currency, there is a possibility of gain or loss in foreign exchange. While it gets converted to local seller currency, the foreign currency’s total value varies depending on the exchange rate. When the currency value inclines after converting, the seller gets a gain in foreign currency.
However, when the currency value declines in the post-conversion process, the seller incurs a foreign exchange loss. When it becomes impossible to find out present exchange rates while the transaction gets recognized, the available exchange rate is further used to calculate the conversion outcome.
Gain on the foreign exchange income statement
A foreign exchange gain in the income statement occurs when an individual or company buys or sells in a foreign currency during currency price fluctuation (i.e., EURUSD, GBPUSD, etc. ) between invoice date and payment date.
All gains and all losses can be realized and unrealized.
Realized vs unrealized gains on foreign exchange
Realized gains and losses are losses and gains that are completed. This would mean that the customer already gets settled for the invoice before the accounting period’s closure. Unrealized profit or losses refer to profits or losses that have occurred on paper, but the relevant transactions have not been completed. Gains and losses in realized and unrealized form through forex transactions vary whether the entire transaction is finished until the end of the total accounting period.
To take an example, let’s assume that the customer buys items that are worth $1000 through the U.S. seller, and the invoice gets valuation at $1,100 on the date of the invoice. The customer then settles the invoice at 15 days post the date of sending the invoice, and the total valuation of the invoice was $1200 while it was converted to USD at the present rate of exchange.
Let us see the foreign exchange gain or loss chart of accounts:
Here, in this case, the seller would have realized gains from foreign exchange of $100 ($1,200 – $1,100). Currency gain gets recorded in the income section’s income statement.
How to Calculate Forex Gain or Loss
To calculate forex gain or loss, subtract the original value of the account receivable in seller currency from the converted seller currency value at the time of collection. A positive result represents foreign exchange gain, while a negative result represents a foreign exchange loss.
Let we see how to calculate forex gain or loss in this foreign exchange gain or loss accounting example:
Foreign exchange gain or loss accounting example
A foreign exchange gain or loss accounting example is when the EUR customer pays the invoice to the US seller. Let seller from the US posts an invoice for 100 EUR to a German customer. Let on the invoice date, 100 EUR is worth 125 USD, and on the payment date value of 100 EUR rise from $125 to $130. In this case, there will be a realized forex exchange accounting gain of $5 ($130-$125=$5).
Let us see another example.
Motorcar Parts of America is a business operating from the U.S. specializing in manufacturing parts for the motor vehicles FIAT (for example). The company has sold its parts to distributors across Germany and the United Kingdom. In the previous financial year, the MPA company sold spare parts worth 100,000 EUR to German distributors and parts worth GBP 100,000 to distributors.
While sending invoices, the value of 1 GBP was at 1.5 USD, while and 1.3 USD was for 1 EUR. Upon receiving invoice payments, one GBP got equal to 1.4 USD, while at that time, one Euro value was at 1.35 U.S. Dollars.
Therefore, to know how to calculate forex gain or loss in conversions, we need to apply the following:
Sales in Germany
= (1.35 x 100,000) – (1.3 x 100, 000)
= 135,000 – 130,000
= $5,000 (Foreign currency gain)
Total sales in UK
(1.4 x 100, 000) – (1.5 x 100, 000)
=140,000 – 150, 000
= -$10,000 (Foreign Currency loss)
Gains and losses that the seller expects to earn while the invoice gets a settlement are unrealized, but the customer fails to pay the invoice after the accounting period’s closure. The gains and losses get calculated by the seller that would get sustained when the customer pays the invoice by the accounting period’s end.
Let’s suppose when the seller sends invoices worth 1,000 EUR, the total invoice’s valuation will remain at 1,100 USD as in the date of the invoice. If the customer doesn’t pay invoices as of the accounting period’s last day, the invoice gets valued at $1,000 at that time.
Upon preparing financial statements for the accounting period, the whole transaction gets recorded as a $100 unrealized loss at actual payment was to be actually received. The losses or gains that were unrealized get recorded in the balance sheet in the owner’s equity section.
Foreign exchange gain loss accounting entry
Foreign exchange gain loss accounting entry can be created when the account is a liability or equity account. In that case, an unrealized gain or unrealized loss report represents a currency gain for liability or equity account. In the next step, credit the unrealized currency gain account (or unrealized currency Gain ) and enter an equal debit amount for the exchange account associated with the liability or equity account.
How to audit foreign exchange gain?
The foreign currency gain can be audited in the income section of the income statement. The profit or loss was determined by taking all revenues and subtracting all operating and non-operating activities.
While preparing yearly financial statements, companies need to report their home currency transactions to make it simple for all stakeholders to know all financial reports. This would mean that all foreign currency transactions need to be converted into home currencies at current exchange rates when businesses recognize transactions.
Although the little math applied here to calculate forex gain or loss would first appear daunting, calculating losses and gains in foreign exchange is just like converting one currency to another from time to time.