one that requires settlement in a currency other than the entity’s functional currency. A foreign currency transaction gain or loss is produced from redeeming receivables/payables that are fixed in terms of amounts of foreign currency received/paid. That is, a business (1) buys or sells on credit goods or services whose prices are denominated in a foreign currency or (2) borrows or lends funds whose amounts payable or receivable are denominated in a foreign currency. Gain or loss results from changes in exchange rates between the functional currency and the foreign currency in which the transaction is denominated. Foreign transaction gains or losses are typically included in the income statement for the period in which the exchange rate changes. Gains or losses on foreign currency transactions deemed to be hedges and intercompany transactions of a long-term investment nature (settlement is not anticipated in the foreseeable future) are not included in net income but are considered as gain or loss on foreign currency translation shown in the stockholders’ equity section.
Assume merchandise is bought by a company in Country X for 100,000 francs. Assume the exchange rate is 4 francs = $1. The journal entry is to debit purchases and credit accounts payable for $25,000 (100,000/4). When the merchandise is paid for, the exchange rate is 5 francs = $1. The cash payment is therefore $20,000. The journal entry is to debit accounts payable for $25,000 and credit cash for $20,000 and foreign exchange gain for $5000.