Foreign Exchange Accounting Rules

Written by carter mcbride
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Foreign Exchange Accounting Rules
Accountants must comply with generally accepted accounting principles (GAAP). (stationary image by pix29 from Fotolia.com)

When a company enters into a foreign transaction it will need to comply with the generally accepted accounting principles related to foreign currency exchange transactions. The most important rules deal with the company's functional currency, the steps involved in recording the transaction and the current exchange rates. Keeping these rules in mind, an accountant will be able to account for foreign currency exchanges.

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Functional Currency

The functional currency is the currency in which the company does its principal business. The facts of each situation will determine the company's functional currency. The general rule of thumb is, whatever currency the business normally uses will be the functional currency of the business. For example, a United States business performs most of its transactions in the U.S. dollar. Occasionally, the company will perform transactions in the euro. The functional currency would be the U.S. dollar.

Transaction Steps

The company must record two transactions any time it has a foreign currency exchange transaction. The first transaction is dated as the day the company enters the transaction. For example, a U.S. company enters into a contract with a German firm to buy widgets for 500 euros. Since the functional currency of the U.S. firm is the dollar, the company cannot record the transaction in euros on its financial statement, so it must convert the amount to dollars using the current exchange rate. The second step is when the company actually pays in euros. If the foreign currency exchange rate changed, there will be either a gain or loss on the transaction. For example, if when they first enter the transaction 500 euros equals £260 and when they pay in euros,500 euros equals £227, then the company will have a £32 exchange gain.

Current Exchange Rate

The current exchange rate is what the company could obtain on the open market. Banks and currency exchanges will provide this amount when the company exchanges the currency. These rates are also available on financial websites such as X-Rates and Yahoo! Finance.

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