Foreign exchange gains and losses occur when a company holds monetary assets or liabilities in a foreign currency, and the exchange rate between that currency and the company’s functional currency changes.
These changes can impact a company’s financial statements and must be accurately accounted for and reported. In this article, we will discuss the accounting treatment of foreign exchange gains and losses, audit risks, and audit assertions associated with this type of transaction.
Accounting Treatment:
Foreign exchange gains and losses are typically accounted for as part of the income statement and are recorded as a separate line item. The accounting treatment of these gains and losses depends on whether the transaction is classified as a hedging relationship or not.
If a transaction is considered a hedge, it is accounted for under the hedge accounting rules in the International Financial Reporting Standards (IFRS) or the Generally Accepted Accounting Principles (GAAP).
For example, if a company holds a foreign currency loan, the fluctuation in exchange rates between the functional currency and the foreign currency can result in exchange gains or losses. These gains and losses are recorded in the income statement as “foreign exchange gains or losses” and are shown as part of the net income for the period.
Audit Risks:
- Misclassification of transactions as hedging relationships
- Inaccurate recording of foreign exchange gains and losses
- Inadequate documentation of foreign exchange transactions
- Inadequate internal controls over foreign exchange accounting
- Failure to follow IFRS or GAAP accounting standards
- Lack of understanding of foreign exchange rates and their impact on financial statements
- Incorrect calculation of foreign exchange gains and losses
- Misapplication of hedge accounting rules
- Inadequate disclosure of foreign exchange transactions
- Misrepresentation of foreign exchange gains and losses in the financial statements.
Audit Assertions:
The following audit assertions are relevant when auditing foreign exchange gains and losses:
- Valuation: The foreign exchange gains and losses have been recorded at the correct exchange rate and accurately reflect the impact on the financial statements.
- Classification: Transactions have been accurately classified as hedging or non-hedging transactions.
- Accuracy: The foreign exchange gains and losses have been recorded correctly and accurately reflect the financial position of the company.
- Completeness: All foreign exchange gains and losses have been recorded and disclosed in the financial statements.
- Existence: Foreign exchange transactions exist and are recorded in the financial statements.
- Rights and Obligations: The company has the right to the foreign exchange gains and losses and has the obligation to pay or receive the corresponding amounts.
- Cut-off: The foreign exchange gains and losses have been recorded in the correct period.
- Disclosure: All relevant disclosure requirements have been met regarding foreign exchange gains and losses.
- Presentation and Disclosure: Foreign exchange gains and losses have been presented and disclosed in accordance with IFRS or GAAP.
- Consistency: The accounting treatment of foreign exchange gains and losses is consistent with previous periods.
Walkthrough Testing:
Walkthrough testing is a key part of the audit procedures for foreign exchange gains and losses. It involves examining the process and controls surrounding the recording, valuation and reporting of foreign exchange transactions and balances. The objective of this test is to gain an understanding of the entity’s processes and controls, and to identify any potential risks or control weaknesses.
The following are the steps involved in walkthrough testing:
- Review the accounting policies and procedures: The auditor should review the entity’s accounting policies and procedures relating to foreign exchange gains and losses to ensure that they are appropriate and consistent with GAAP.
- Identify key foreign exchange transactions: The auditor should identify the key foreign exchange transactions that are likely to result in gains or losses. This may include transactions involving foreign currencies, currency derivatives and other financial instruments.
- Understand the process: The auditor should understand the process by which the entity records and reports foreign exchange gains and losses. This may include understanding how exchange rates are determined, how foreign exchange gains and losses are recognized, and how they are included in the financial statements.
- Test the controls: The auditor should test the controls in place to ensure that foreign exchange gains and losses are accurately recorded and reported. This may include testing the accuracy of exchange rate calculations, testing the completeness and accuracy of the accounting records, and testing the accuracy of the financial statements.
Test of Control:
Test of control is another important part of the audit procedures for foreign exchange gains and losses. The objective of this test is to evaluate the entity’s controls over foreign exchange transactions and balances to determine their effectiveness in mitigating risk.
The following are the steps involved in test of control:
- Identify controls: The auditor should identify the key controls that the entity has in place to mitigate the risks associated with foreign exchange gains and losses. This may include controls over the accuracy of exchange rate calculations, the completeness and accuracy of accounting records, and the accuracy of financial statements.
- Evaluate the design of controls: The auditor should evaluate the design of the controls to determine if they are adequate and effective in mitigating the risks associated with foreign exchange gains and losses.
- Test the operating effectiveness of controls: The auditor should test the operating effectiveness of the controls to determine if they are functioning as intended. This may include testing the accuracy of exchange rate calculations, testing the completeness and accuracy of the accounting records, and testing the accuracy of the financial statements.
Substantive Audit Procedures
Substantive audit procedures are a critical aspect of auditing foreign exchange gains and losses. They are designed to provide evidence about the completeness, accuracy, and validity of the financial information being audited.
The objective of substantive audit procedures is to identify potential misstatements or inaccuracies in the financial information.
Here are ten substantive audit procedures that can be performed when auditing foreign exchange gains and losses:
- Review of transaction processing: This procedure involves reviewing the transactions processed in the foreign exchange accounts to ensure that all transactions have been recorded accurately.
- Review of exchange rate data: This procedure involves reviewing the exchange rate data used to translate foreign currency amounts into the functional currency.
- Analysis of exchange rate fluctuations: This procedure involves analyzing the exchange rate fluctuations over the period being audited to identify any significant changes that may have impacted the financial information.
- Review of journal entries: This procedure involves reviewing the journal entries that have been recorded in the foreign exchange accounts to ensure that they are accurate and complete.
- Review of supporting documentation: This procedure involves reviewing the supporting documentation for foreign exchange transactions, such as invoices and receipts, to ensure that they are complete and accurate.
- Review of relevant contracts and agreements: This procedure involves reviewing contracts and agreements that may have an impact on foreign exchange gains and losses to ensure that they are accurate and complete.
- Review of reconciliation: This procedure involves reviewing the reconciliation of the foreign exchange accounts to ensure that all transactions have been recorded accurately and that the balances are correct.
- Testing of key estimates: This procedure involves testing key estimates used in the calculation of foreign exchange gains and losses, such as the expected rate of exchange.
- Review of disclosure: This procedure involves reviewing the disclosures related to foreign exchange gains and losses to ensure that they are accurate and complete.
- Review of internal controls: This procedure involves reviewing the internal controls related to the foreign exchange accounts to ensure that they are effective and adequate.
It is important to note that these procedures are not exhaustive and may vary based on the size and complexity of the entity being audited. The auditor must use professional judgment to determine the appropriate substantive audit procedures to be performed based on the specific circumstances of each audit engagement.
