Foreign exchange gains and losses arise from foreign-currency-denominated international transactions. A change in the foreign exchange rate during the time between transaction date and settlement date increases or decreases the transaction value as recorded in a company's domestic currency. Gains or losses from change in transaction value are recognised before settlement date and realised upon settlement. At balance sheet date, the recorded transaction balance is adjusted to reflect the current exchange rate. The Financial Accounting Standards Board (FASB) requires that any foreign currency transaction gain or loss be included in determining net income.
Treatment on Transaction Date
An international transaction may be entered into in a manner that produces for a domestic company future receivables or payables fixed in the amount of a foreign currency. However, the value of the transaction shall be recorded on the company's accounting books in its own currency. At the date the transaction is recognised, according to FASB rule FAS52 16a, the receivable or payable from the transaction should be measured and recorded in the company's home currency using the exchange rate in effect at the transaction date.
Treatment on Balance Sheet Date
As the foreign exchange rate changes from time to time, the transaction value as recorded on the company's balance sheet in its own currency changes accordingly. If the transaction takes more than one accounting period to settle, at the first balance sheet date, the transaction value is adjusted to the fair value to reflect the current exchange rate. Further adjustments are performed at each subsequent balance sheet date until the transaction settlement date. Gains or losses from fair-value adjustments are recognised in net income in the period they occur.
Treatment on Settlement Date
On transaction settlement date or the most recent balance sheet date, whichever is later, transaction value as recorded on the balance sheet is measured and adjusted for the final time using the exchange rate at the time of the settlement. Any gains or losses from the settlement are realised in the period in which the settlement takes place. The balance sheet item is subsequently removed with the cash receipt or payment, according to the Financial Education website. Gains and losses from prior periods up to the settlement time may have been cancelled out from each other. But it is necessary to report those unrealised gains and losses when the exchange rate changes. It tells users of financial statements about the potential effects on company cash flows from future transaction settlement.
Gains and losses from certain foreign currency transactions are not required to be included in net income, but instead are reported in other comprehensive income in the equity section of the balance sheet. The exceptions permitted by FASB provides companies some relief from potential earnings pressures. One such exception concerns inter-company transactions that are long term in nature with no settlement date planned or anticipated in the foreseeable future.