Introduction
A foreign exchange transaction, often abbreviated as forex, refers to the buying or selling of one currency in exchange for another currency. These transactions occur in the foreign exchange market, which is the global marketplace for trading currencies. Foreign exchange transactions are essential for facilitating international trade and investment.
Various national and multinational companies engage in foreign currency transactions to buy and sell products in international markets. Proper accounting and timely auditing of these forex transactions are crucial for smooth operations. There are firms and LLPs that specialize in providing such services, facilitating the accounting and timely verification of forex transactions.
Companies involved in buying and selling goods using foreign currency may experience both realized and unrealized gains or losses due to fluctuations in foreign exchange rates. The explanation for this is as follows:
Realized foreign exchange Gain or Loss:
A realized foreign exchange gain or loss occurs when the company completes a transaction and exchanges domestic/foreign currency for another at a specific exchange rate.
For example, if a company buys goods from a foreign supplier and pays in that supplier’s currency, it will record a realized gain or loss when it converts its home currency into the supplier’s currency to make the payment.
The realized gain or loss is calculated by comparing the exchange rate at the time of the transaction with the exchange rate at the time the transaction is settled or paid.
Unrealized foreign exchange Gain/Loss:
An unrealized foreign exchange gain or loss occurs when the company holds foreign currency assets or liabilities but has not yet completed the transaction to convert them into its domestic currency.
For example, if a company holds accounts receivable or accounts payable in a foreign currency, the value of these assets or liabilities will fluctuate with changes in exchange rates. The resulting gain or loss is considered unrealized until the transaction is completed.
Unrealized gains or losses are recorded on the company’s balance sheet as part of comprehensive income or equity, but they do not affect net income until they are realized through an actual transaction.
Accounting Treatment:
Realized gains and losses are typically recognized in the company’s income statement in the period when the transaction occurs.
Unrealized gains and losses, on the other hand, are often reported in the comprehensive income section of the company’s financial statement, but they do not affect net income until they are realized through an actual transaction.
Let’s us consider a hypothetical company, XYZ Inc., based in India, which imports goods from Europe and sells them domestically. The company conducts its transactions in Indian Rupees (INR) but deals with suppliers who invoice in euros (EUR).
Realized Gain/Loss Example:
XYZ Inc. purchases goods worth €100,000 from a European supplier when the exchange rate is 1 EUR = 80 INR. Therefore, the cost of goods in INR is:
Cost in INR = €100,000 * 80 = ₹ 80,00,000
After some time, when XYZ Inc. makes the payment to the supplier, the exchange rate has changed to 1 EUR = 82 INR.
The actual payment made by XYZ Inc. in INR is:
Payment in INR = €100,000 * 82 = ₹ 82,00,000
Realized Gain/Loss = Payment in INR – Cost in INR
= ₹82,00,000 – ₹80,00,000
= -₹2,00,000 (Realized Loss)
Unrealized Gain/Loss Example:
XYZ Inc. also has accounts payable of €50,000 to another European supplier, but the payment is yet to be made.
When the accounts payable were initially recorded, the exchange rate was 1 EUR = ₹80 INR, so the liability in INR was:
Liability in INR = €50,000 * 80 = ₹ 40,00,000
However, at the end of the accounting period, the exchange rate has changed to 1 EUR = 78 INR.
The unrealized gain/loss on the accounts payable is calculated as follows:
Unrealized Gain/Loss = Current Liability in INR – Initial Liability in INR
= (€50,000 * 78) – ₹40,00,000
= ₹39,00,000 – ₹40,00,000
= ₹1,00,000 (Unrealized Gain)
In this example, the realized loss occurred when the company actually made the payment in INR at a less favourable exchange rate than when the transaction was initially recorded. The unrealized gain arose from the fluctuation in the exchange rate affecting the value of the accounts payable that have not yet been settled.
Transactions recorded in the company’s books are expected to adhere to the exchange rates stipulated by the Reserve Bank of India (RBI). However, it is observed that companies occasionally employ exchange rates differing from those prescribed by the RBI for specific transactions or throughout their financial records. During the auditing process, it is imperative for auditors to consider and rectify such discrepancies by making necessary adjustments to align the entries with the RBI’s prescribed rates
Consider another scenario: XYZ Inc., a hypothetical company based in India, conducts its transactions using exchange rates different from those prescribed by the Reserve Bank of India (RBI).
In one instance, XYZ Inc. sold goods valued at €100,000 to a European supplier. According to the RBI’s exchange rate, 1 EUR equal to 80 INR. However, XYZ Inc. recorded the transaction in its books at a rate of 82 INR per EUR. During the audit, the discrepancy was noted by the auditor, highlighting that the recorded rate did not align with the RBI’s rates. Consequently, the sales figures were inflated due to the variance in exchange rates. The auditor advised XYZ Inc. to adjust their sales by reducing ₹2 (82 – 80) to accurately reflect the transaction in accordance with the RBI’s prescribed rate.
Use of Modern Technology for Accounting of Forex Transactions
In modern business operations, the efficient management of foreign exchange transactions is paramount. Software solutions, including specialized modules and customizations like Tally TDL (Tally Definition Language), play a crucial role in accurately recording foreign exchange gains or losses in the books of accounts for the sale and purchase of goods.
These software systems streamline the complex process of accounting for transactions involving multiple currencies. Through comprehensive features, they facilitate the recording of transactions at the prevailing exchange rates, ensuring accuracy and compliance with accounting standards.
For instance, TDL can enable automatic calculations of foreign exchange gains or losses based on real-time exchange rate fluctuations. It can also provide reports and analyses to track and manage currency exposure effectively.
By leveraging software solutions and Tally TDL, businesses can maintain transparent and precise records of foreign exchange transactions, thereby enhancing financial reporting integrity and decision-making processes. These tools not only streamline accounting processes but also mitigate risks associated with currency fluctuations, ultimately contributing to the overall efficiency and profitability of the organization.
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Authors: Harsh Shah | Associate Consultant | Email: blogs@bilimoriamehta.com | Mobile: 98709 25375, 99305 98581
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