a c c o u n t s d e m y s t i f i e d
Trading in foreign currencies
Suppose you sold some products to a customer in the USA for $7,000 to
be paid 90 days after the date of the transaction. You would translate the
$7,000 into pounds sterling at the exchange rate prevailing on the day
of the transaction and enter the transaction in your accounts. Assume
the exchange rate was $1.75 to the pound; this would make the $7,000
When the American customer pays (90 days later), the exchange rate is
likely to be different. Assume it is $1.60 per £; this would mean that the
customer is effectively paying you £4,375, when your accounts say you
should be getting £4,000. By waiting 90 days to be paid, you have made a
profit of £375.
This profit is known as an exchange gain. Naturally, if the exchange
rate had gone the other way, you would have made an exchange loss. If
these exchange gains or losses are material, they will be disclosed in the
accounts of the company.
Presumably, if a large proportion of your sales are overseas, your profits could be
substantially affected by exchange gains or losses?
Yes, it’s a major issue for some companies. Such companies employ
people in their finance departments to hedge the exposure. This means
creating an exposure to the foreign currency in a way that is equal and
opposite to the exposure you have from the original transaction. Then,
whatever happens to the exchange rate, you should end up with the same
amount of money in your own currency.
You would be surprised, however, how many companies choose not to
hedge their exposure, in the hope of making an exchange gain. Effectively
they are speculating on the currency markets. This is what banks have
whole departments doing 24 hours a day. Ordinary companies really
should not be trying to beat the banks at their own game – they won’t be
able to in the long run and are virtually certain to end up making more
losses than gains.