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What is the journal entry for foreign currency transactions?

What is the journal entry for foreign currency transactions?

When it comes to foreign currency transactions, especially in terms of B2B international remittances, it is understandable that you’d want to keep a neat record of journal entries. 

After all the RBI does not go easy on companies when it comes to business outward remittances, for it keeps an eye on every penny that leaves the country. 

The financial service you use should provide you with a dashboard with all your transaction history, international vendor details, etc. 

But ,usually, that is not the case

So how do you go about it? 

Let’s break it down for you! 

#1 How do you handle foreign currency transactions?

Foreign currency transactions involve buying or selling goods and services using a currency different from your usual currency. You convert the amount at the exchange rate on the transaction date to record it correctly in your financial records. This process helps account for any gains or losses due to changes in exchange rates.

Foreign currency remeasurement or translation is about adjusting the financial statements of a foreign company or subsidiary. You convert their financial figures from their usual currency to your reporting currency (often the local currency). This adjustment uses the exchange rate as of the balance sheet date to update values, or it uses average rates to convert income items. This way, your financial statements show how changes in currency values affect the foreign company's financial position and performance accurately.

#2 What are the four methods of foreign currency transaction?

In the context of business international remittance from India, the four methods of foreign currency transaction typically refer to:

  1. Spot Exchange Rate Method: Using the current exchange rate at the time of remittance to convert Indian Rupees (INR) into foreign currency.
  2. Forward Exchange Rate Method: Agreeing on a future exchange rate when initiating the remittance, ensuring a known rate for converting INR into foreign currency on a specified future date.
  3. Historical Exchange Rate Method: Referring to exchange rates that were in effect on the date when the remittance transaction originally occurred, if needed for accurate record-keeping.
  4. Average Exchange Rate Method: Calculating an average exchange rate over a specific period, such as a month or a quarter, to convert INR into foreign currency when multiple remittances are involved during that period.

#3 What's the difference between foreign currency transactions and foreign currency translation/ remeasurement? 

In the case of business international remittance in India:

  1. Foreign Currency Transactions: These involve buying or selling goods, services, or financial assets where payments or receipts are made in a currency other than the Indian Rupee (INR). The focus is on converting INR into foreign currency or vice versa at the prevailing exchange rate at the time of the transaction. This process ensures accurate recording of financial transactions in the company's books.
  2. Foreign Currency Translation/Remeasurement: Foreign Currency Translation/Remeasurement involves converting the financial statements of a foreign subsidiary or entity from its local currency to INR (Indian Rupees) for reporting purposes. 

Here’s how it works:

  • Translation: This process converts balance sheet items (such as assets and liabilities) at the exchange rate on the balance sheet date. It ensures these items are accurately represented in INR in the consolidated financial statements.
  • Remeasurement: Remeasurement converts income statement items (like revenues and expenses) using average exchange rates for the period. This step reflects the financial performance of the foreign entity in terms of INR, considering currency fluctuations over time. The objective is to consolidate the financial results of foreign operations into INR, providing a clear picture of how currency movements impact the overall financial performance and position of the company.

#4 Where should foreign currency transactions be reported?

In Indian international business, when you send money in foreign currency, you need to tell the Reserve Bank of India (RBI) about it through approved banks. Here's how it works:

  • Authorized Banks: Banks in India that are allowed by the RBI to handle transactions involving foreign currency for international business. These banks act as go-betweens and report these transactions to the RBI.
  • Reporting to RBI: These authorized banks have to regularly tell the RBI about the details of these foreign currency transactions. This reporting makes sure everything follows the rules about exchanging money and keeps track of how much foreign money comes in and goes out of India.
  • Why and Papers Needed: When companies do business across borders and send foreign money, they must give the bank all the papers like invoices and contracts. These papers show why the money is being sent.

Following the Rules: Reporting these foreign money transactions to the RBI makes sure everything is done the right way according to Indian laws. This keeps the money system stable and makes sure everyone knows what's happening with money going in and out of the country.

#5 Understanding Journal Entries in a Foreign Currency Transaction 

In the context of international business remittance from India:- 

Transaction Recording: When an Indian business makes a payment in a foreign currency, such as for importing goods or services, the transaction is initially recorded in the company’s books. For example, if a payment of 10,000 USD is made for imports and the exchange rate is 1 USD = 83 INR, the entry would be:

  • Debit: Import Expenses (or Inventory) 10,000 USD
  • Credit: Accounts Payable 10,000 USD

Currency Conversion: Convert the foreign currency amount into Indian Rupees (INR) using the exchange rate applicable on the transaction date. Continuing the example:

  • Debit: Import Expenses (or Inventory) 830,000 INR (10,000 USD * 83 INR/USD)
  • Credit: Accounts Payable 830,000 INR

Handling Exchange Rate Fluctuations: If the exchange rates change between when the transaction happens and when it's settled, we update the recorded amounts accordingly. This update helps us capture any gains or losses from the currency exchange, which can impact how profitable the transaction is. These gains or losses are shown in the income statement. 

Compliance and Documentation: Ensure all transactions comply with regulations set by the Reserve Bank of India (RBI) regarding foreign exchange transactions. Proper documentation, including invoices and contracts, should support each transaction to ensure accurate recording and regulatory adherence.

Periodic Revaluation: Periodically revalue balance sheet items denominated in foreign currency (e.g., accounts receivable or payable) using the exchange rate at the balance sheet date. Any resulting gain or loss should be recorded in the income statement to provide a true financial picture.

#6 Intercompany Settlement for an international business transaction

Let us explain this with an example. 

Consider Tech Solutions Pvt. Ltd., a software development firm based in Bangalore, India, with a subsidiary, Tech Solutions Inc., located in the United States. Here’s how an outward remittance transaction between the Indian headquarters and its U.S. subsidiary might unfold:

  1. Transaction Initiation: Tech Solutions Pvt. Ltd. initiates a payment to Tech Solutions Inc. in the United States for software development services rendered. The payment amount is 50,000 USD.
  2. Exchange Rate Calculation: On the transaction date, the exchange rate is 1 USD = 83 INR. Therefore, the equivalent amount in Indian Rupees (INR) is calculated as :
    • 50,000 USD * 83 INR/USD = 4,150,000 INR
  3. Journal Entry in Tech Solutions Pvt. Ltd.'s Books:
    • Debit: Software Development Expenses (or Intercompany Expenses) 4,150,000 INR
    • Credit: Bank Account (or Accounts Payable) 4,150,000 INR
  4. Intercompany Settlement: Tech Solutions Inc. in the U.S. receives 50,000 USD in their bank account and records the transaction as:
    • Debit: Bank Account 50,000 USD
    • Credit: Intercompany Receivable 50,000 USD
  5. Exchange Rate Fluctuations: If the exchange rate changes between the transaction date and the settlement date, Tech Solutions Inc. may adjust its books to reflect the actual amount received in USD after conversion into INR.
  6. Documentation and Compliance: Both Tech Solutions Pvt. Ltd. and Tech Solutions Inc. maintain proper documentation, including invoices and intercompany agreements, to support the transaction. This ensures compliance with RBI regulations governing outward remittances.

#7 What is the journal entry to record a foreign exchange transaction gain?

The journal entry to record a foreign exchange transaction gain varies based on whether the gain is realized or unrealized:

  1. Realized Gain:
    • A realized foreign exchange gain occurs when an actual transaction is settled at a more favorable exchange rate than initially recorded. For example, if an Indian company receives payment in USD, and the exchange rate improves when converting USD to INR upon settlement, the journal entry would typically be:
      • Debit: Bank Account (or Accounts Receivable) in INR (amount received after conversion)
      • Credit: Exchange Gain (recognized in the Income Statement)
  2. Unrealized Gain:
    • An unrealized foreign exchange gain occurs when there is an increase in the value of an asset or liability denominated in a foreign currency, due to exchange rate fluctuations, but the transaction has not yet been settled. For instance, if an Indian company holds an asset in USD and the exchange rate improves, increasing the value of the asset in INR before the actual sale or settlement, the journal entry would generally be:
      • Debit: Exchange Gain (recognized in the Income Statement)
      • Credit: Unrealized Gain Reserve (reported in the Balance Sheet)

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