How are foreign currency transactions recorded and what exchange rate do you use?

Foreign currency transactions arise when a company enters into a transaction denominated in a currency other than its functional currency. The key is understanding which exchange rate to use and when to recognize gains or losses.

Exchange Rate Rules:

Monetary vs Non-Monetary Items:

• Monetary items (cash, receivables, payables): Remeasured at the closing rate -- gains/losses go to the income statement
• Non-monetary items at historical cost (inventory, PP&E): Remain at the historical rate -- no remeasurement gain/loss
• Non-monetary items at fair value: Remeasured at the rate when fair value was determined

Worked Example -- Cedar Mills Inc.:

Cedar Mills (USD functional currency) purchases inventory from a Japanese supplier for JPY 10,000,000 on November 1.

Journal Entries:

Nov 1 -- Record purchase:

• DR Inventory: $66,667
• CR Accounts Payable: $66,667

Dec 31 -- Remeasure A/P (monetary item):

New A/P value: JPY 10,000,000 / 145 = $68,966

• DR Foreign Exchange Loss: $2,299
• CR Accounts Payable: $2,299

(The yen strengthened, making the payable more expensive in USD)

Jan 15 -- Payment:

Payment in USD: JPY 10,000,000 / 148 = $67,568

A/P balance: $68,966

• DR Accounts Payable: $68,966
• CR Cash: $67,568
• CR Foreign Exchange Gain: $1,398

(The yen weakened from Dec 31 to Jan 15, creating a gain on settlement)

Net FX impact: Loss of $2,299 + Gain of $1,398 = Net loss of $901 across both periods.

Exam Tip: Remember that inventory (a non-monetary asset) stays at the historical rate of $66,667 -- it is NOT remeasured. Only the payable (monetary liability) is remeasured at each balance sheet date.

Practice foreign currency transaction problems in our CFA Level I question bank.