In our last post, we explored what FX risk is and why it matters to businesses of all sizes. The core takeaway was that to manage this risk, you first have to understand and measure your exposure. But what does that look like in practice?
The first step in any risk management strategy is to move from hoping to knowing. You have to see the risk, quantify it, and then track its journey through your financial statements. In this post, we’ll walk through a real-world example to show you exactly how to record and calculate your foreign exchange exposure and prepare your business for whatever the market throws your way.
The Problem with a Simple Invoice
Let’s imagine you are an EU-registered company with a business currency of EUR. You receive a 1,000 GBP invoice from a UK-based vendor. At first glance, this looks like a straightforward payable. However, the moment that invoice is created, you are exposed to FX risk.
The risk is the foreign currency balance itself (the 1,000 GBP). The exposure is the unrealized gain or loss that will be created by the inevitable fluctuations in the currency pair (EUR/GBP). You need to be able to track this exposure until the invoice is finally settled.
The Anatomy of a Foreign Currency Payable
To properly track this exposure, you need to think in parallel. When you initially receive the invoice, you record it at the spot rate. If the EUR/GBP rate is 1.20, your payable is recognized as both 1,000 GBP and 1,200 EUR. From an accounting perspective, your entry looks something like this:
Debit Cost: 1,200 EUR (1,000 GBP)
Credit Payable: 1,200 EUR (1,000 GBP)
Now, let’s say this invoice was received on the 15th of the month and is due in 30 days. At month-end, you have to close your books. If the rate has moved to 1.25, your 1,000 GBP payable now has a EUR equivalent of 1,250. This creates an unrealized loss of 50 EUR (1,250 – 1,200).
To account for this, you record a “virtual” loss on your financial statements at month-end:
Debit Unrealized FX Loss: 50 EUR
Credit Payable: 50 EUR
This entry reflects the loss in value on paper. It’s an important step for financial reporting, but because the invoice hasn’t been settled, it’s not a cash loss. This is why on the first day of the new month, you would reverse this entry.
Since this is a “virtual loss”, the entry needs to be fully reversed on the next day (ie 1st of new month), to assure the “virtual” loss is nullified when looking at YTD fianancials.
The Outcome and Its Impact
Now, for the sake of a complete story, let’s assume that when you actually settle the invoice on the 15th of the new month, the rate has moved to a favorable 1.15. You ask your bank to convert 1,150 EUR to 1,000 GBP to make the payment. You’ve secured a 50 EUR gain (1,200 – 1,150) plus an additional 10 EUR (example amount) conversion fee from your bank. Your final accounting entry would record the settlement and the final realized gain.
The end result was a gain, but that gain would have looked very different in your month-end reports if you didn’t manage your exposure. You would have recorded a loss one month and a gain the next, which can make it very difficult to understand your true performance. By running parallel balances in both currencies, you can always keep a clear, real-time track of your exposure.
Thinking Like a Manager, Not Just an Accountant
This one-invoice example scales up very quickly. Imagine you have dozens of invoices, both payables and receivables, in multiple currencies. Manually tracking all of them is not only a pain—it’s a massive business risk that could span over multiple months.
A few key takeaways for a manager:
Don’t Rely on Luck: Our example had a happy ending, but it could have easily gone the other way. You were exposed, and your month-end reports showed a loss. Don’t simply sit and hope for a favorable rate.
Embrace Automation: If international transactions are core to your business, a manual approach is not sustainable. Choose an accounting system that can handle these complex entries and revaluations automatically, or ask for help (alternative full or semi-automatic analytical solutions can be built).
Weigh the Cost of Mitigation: Does the cost of a hedging service make sense for your business? If the statistical loss from FX volatility is less than the cost of a full hedging service, it might not be worth it.
Think End-to-End: Always consider all costs, including conversion fees, and aim for minimal and transparent fees.
The final point is the most important: The rates don’t need to be exact for sanity checking your entries. Always think high-level and make it simpler, but always do the sanity check from both balance sheet and income statement (profit and loss) side.
In the next blog post, we will build on this foundation and explore How to Control and Explain FX Results.