• Accounting , Economics , Finance ,
• 09 Aug

Calculating Foreign Exchange gains and losses is important for companies that do business internationally. We won’t get into complicated Forex trading but look at how exchange rates changing over time can affect your accounts receivable and accounts payable. We’ll also define basis points and work them into our discussion.

Why do we have gains or losses on exchange rates?

We take on risk when we sell something on account. Our revenue goes up and our accounts receivables go up. Then hopefully at some point in the future, we are paid. This is pretty straight forward but when we add different currencies in the mix it complicates things.

If we are working in dollars and sell something in euros, the fluctuations in the exchange rate will change the amount of dollars we can expect to receive in the future. Let’s take a look at the formula. Essentially we are finding the difference between two products which we’ll see in our example. If the exchange rate goes up, you have a gain, if it goes down, you have a loss.

Formula

where

Price of Sale

FX Rate at Time of Sale

FX Rate at Time of Payment

Price

This is the price in “your” currency. It is the basis in determining the gain or loss.

FX Rate at Time of Sale

This is the exchange rate at the time of the sale.

FX Rate at Time of Payment

This is the exchange rate at the time of receiving payment.

Walk Through Example

Let’s say an American company sells a widget for 20,000 euros at an exchange rate of 0.89. Then when we collect the cash, the rate has gone up to 0.92. Below we see the first entry at the time of the sale. The second entry happens when we receive payment. We can see our formula used in the Gain on FX line.

Other Considerations and Terminology

Basis Points

Also called point in percentage (pip) or tick, basis points are the lowest decimal point in an exchange rate. Often the 4th decimal place out. So if the Euro to dollar exchange rate (FX) is 1.1127 on Tuesday, this means that we can exchange 1 Euro and get 1.1127 dollars. The next day, the FX rate goes up to 1.1128. We can say that the FX rate has increased by 1 basis point. This style or format allows us a common language when we talk about changes in rates.

Forex

In studying and having conversations about exchange rates, you’ll see this term forex come up. Forex is trading in currencies similar to the stock and bond markets. If you find that you have a lot of volatility due to exchange rates, there are more advanced finance tools such as currency options, FX swaps, and futures for hedging exchange rate risk.