When the books are closed at the end of an accounting period, balances in the receivable and payable accounts usually exist. When these balances reflect foreign currency transactions, there may be unrealized gains or losses due to the change in the value of the foreign currency. There are two approaches to handling the unrealized gains/losses:

• Deferral Approach
• Accrual Approach

The following example illustrates the effects of these two methods.

On December 15th Company A, which is based in the United States, sells 10 widgets to Company B whose preferred currency is euros (€). The amount of the transaction is €1,100 which corresponds to the U.S. dollar value of $1,000. Company A extends a 30-day credit policy to Company B, and Company B makes a payment of €1,100 on January 15th. Company A's books, however, need to be closed on December 31st. The following table shows the value of the euro and the U.S. dollar for the dates in this example.

The General Ledger (GL) entries for the sale are the same regardless of which approach is used for the ending balances.

Deferral Approach

Using the deferral approach, foreign currency gains or losses are deferred on the balance sheet until cash is actually paid or received and require no General Ledger GL entries at the end of the period. When cash is paid or received, a realized foreign exchange gain or loss is included as income. Since the currency spot rate on January 15th was 1.05 euro to 1 U.S. dollar, the €1,100 transaction from December 15th is valued at $1,047.62 resulting in a gain of $47.62. This deferral approach is not compliant with U.S. Generally Accepted Accounting Principles (GAAP), but is used in some foreign countries.

Accrual Approach

The accrual approach toward unrealized foreign currency exchange gains and losses tracks the unrealized gain or loss from the foreign currency transaction during the period in which the exchange rate changes. A gain or loss gets recognized between the date the order was marked as shipped and the date the accounting period ended even though a payment has not been received. Subsequent gains or losses between the accounting period end date and the date of payment are recognized in the accounting period in which they occur. This concept is also known as "marking assets/liabilities to market." The accrual approach is the method sanctioned by Financial Accounting Standards Board, Statement 52, Foreign Currency Translation (FASB 52). 

In this example, the close of the accounting period is December 31st. The accrual approach generates the following entries which decreases the Accounts Receivable account by $17.86, reflecting the change in the exchange rate from €1.10 to €1.12 per 1 U.S. dollar. To make the source of income clear, the loss is posted to the Foreign Exchange Loss account rather than to the Sales account.

On January 15th, Company A receives a €1,100 payment from Company B. Since the exchange rate is now 1.05 euro to 1 U.S. dollar and has changed from the value on December 31st, the effect (a foreign exchange gain) needs to be posted to the general ledger.

Handling foreign currency transactions using the accrual approach complies with U.S. GAAP and FASB 52 because the gains or losses are kept separate from the sales account.