Our last post demonstrated how forex gain/loss is created. Now we turn to GAAP’s confusing guidance on what to do with forex gain/loss.

The Wiley GAAP Codification Edition says:

Making the sale is the result of an operating decision, while bearing the risk of fluctuating spot rates is the result of a financing decision…  because the risk of a foreign exchange transaction loss can be avoided by (1) making immediate payment… or (2) fixing the price of the purchase in US dollars instead of in the foreign currency, or (3) by entering into a forward exchange contract to hedge the exposed asset (cash). The fact that “US Company” did not take any of these actions is reflected by recognizing foreign currency transaction gains or losses in its income statement (reported as financial or nonoperating items) in the period during which the exchange rates changed. This treatment has been criticized, however, because earnings will fluctuate because of changes in exchange rates and not because of changes in the economic activities of the enterprise. The counterargument, however, is that economic reality is that earnings are fluctuating because the management chose to commit the reporting entity to a transaction that exposes it to economic risks and, therefore, the case can be made that the volatility in earnings faithfully represents the results of management’s business decision.

We think Wiley’s analysis of recognizing all forex gain/loss on the current income statement misses half of the controversy.

Let’s consider “Other Comprehensive Income,” that strange classification of things that are not included in net income. There is a list of things that must be included in OCI at ASC 220-10-55-2.

The list elements share a common theme – they are all things whose impact on net income cannot be determined because their impact has not stopped changing yet. They are transactions whose profit or loss wanders with the passage of time, until the company takes some future action that will allow the transaction to be determinable. Until then, any impact on net income could be reversed in a matter of weeks. Reporting such items in net income would be deceptive.

OCI includes:

• Temporary (unrealized) gain/loss on securities
• Temporary (unrealized) gain/loss on hedging

These are transactions that take longer than our accounting principle of periodicity can handle. Their start time took place before the balance sheet date, and the end time has not yet happened. When the transaction is concluded, a realized gain/loss will be calculated and included in net income… but until then, all we can do is estimate what that actual gain/loss might someday be, by pretending the transaction was concluded at the balance sheet date – and treating that temporary estimate as OCI excluded from Net Income.

Forex gain/loss associated with unpaid bills that must eventually be settled in CAD, but which have not been settled as of the balance sheet date, would seem to fall squarely into this category. The forex gain/loss associated with a 10% change in the forex rate between incurring the expense and period end may well be reversed by a 15% swing the other way between period end and when the bill is paid.

GAAP, however, suggests any temporary gain/loss calculated at period end belongs in Net Income.

ASC 830-20-35-1 says:

A change in exchange rates between the functional currency and the currency in which a transaction is denominated increases or decreases the expected amount of functional currency cash flows upon settlement of the transaction. That increase or decrease in expected functional currency cash flows is a foreign currency transaction gain or loss that generally shall be included in determining net income for the period in which the exchange rate changes.

Note that we’ve highlighted the word “generally” – because there are plenty of exceptions, caveats and gotchas sunk into the more obscure sections of ASC 830. We’ll tackle those in our next post.

Recording foreign currency exchange gains and losses (“forex gain/loss”) seems mysterious to many. The treatment prescribed by GAAP seems even more mysterious.

Money issued by different countries can be exchanged at a bank. But it would be easier to understand if you imagined a car dealer straddling the US-Canadian border. Let’s pretend all of her cars cost her $10,000 each.

Depending on the weather, the day of the week, how busy she is, or how nice you are to her, she might sell you a car for $20,000, plus or minus.

One of the factors she considers is the relative “worth” of the currency she is receiving from her customers. If, say, one side of the border (let’s call it the South side) had a federal government wildly spending money it doesn’t have, just printing the stuff up out of cheap ink and paper, she might decide that she would start charging 10% more for her car, if her customer was paying with that country’s currency.

Soon, moneychangers all along the border would demand $1.10 of the southern country’s money to pay off each $1 of bills denominated in the northern country’s money.

Such transactions, by themselves, don’t give rise to foreign currency conversion gain/loss – for that, you have to mix in the accountants.

Accrual accounting requires that expenses be recognized when they are incurred, rather than when they are paid. It is the timing difference between those two events that gives rise to forex gain/loss.

Here’s how it works:

If the “reporting currency” in which you present your financial statements are US Dollars (USD), and the exchange rate between Canadian Dollars (CAD) is 1.1 (where we left things along that imaginary border four paragraphs ago), and you get a legal bill of $909 denominated in Canadian dollars (CAD) , then you record an expense of $1,000 USD. [$909 x 1.1 = $1,000].

Three months later, you want to pay that bill. However, over the intervening three months, the exchange rate has gone from 1.1 to 1.2. That means you will have to come up with $1,091 USD in order to pay your lawyer $909 CAD [$909 x 1.2 = $1,091]. The $91 USD required to pay your bill today, over the $1,000 USD legal expense you recorded three months ago, is your forex loss.

Another way to look at it: forex gain loss is the difference in exchange rates between when you incur an expense and when you pay it [(1.1 - 1.2) * $909 = <$91>].

Next: How GAAP treats forex gain/loss.