In today’s global economy, thousands of businesses around the world are completing transactions with businesses in countries other than their own. Although this can complicate the accounting process, there are certain steps that businesses must take when recording these transactions. Whenever a company conducts a foreign transaction, it must comply with accounting principles that have been generally accepted as proper procedure for dealing with foreign currency exchange transactions. There are several rules for accounting for these transactions, but the most important rules relate to the functional currency of a company, the steps involved in the transaction recording process, and the accounting for current exchange rates. By keeping these rules in mind, foreign currency exchanges through foreign transactions will be clearly accounted for.
Current Exchange Rate
The current exchange rate a company can expect to receive on the open market between their native currency and a foreign currency changes daily. Accountants can look up the current exchange rate on sites like Yahoo Finance or X-Rates, or they can receive the information from banks and currency exchanges. Every time a company completes a foreign transaction in a currency other than their native currency, an accountant must use the foreign exchange rate to convert the currency into the company’s native currency, which is also called the functional currency.
The currency that a company conducts its principle business in is known as the functional currency. Although certain situations may arise that causes the functional currency to change, the general rule of thumb dictates that a business’s functional currency is whatever currency that a business typically uses. For example, a Japanese business conducts its business and performs the majority of its transactions using the Japanese yen. The company may occasionally conduct transactions in the Australian dollar or Euro, but the company’s functional currency would be the yen.
Any time a foreign currency exchange transaction takes place, a company must record two separate transactions. The first transaction is a normal transaction that is dated the day that the transaction is performed. For example, if a French company enters into a contract to buy alternators from a U.S. company for $25,000, the transaction cannot be recorded in U.S. dollars on its financial statement because its functional currency is the Euro. Instead, the company must convert the dollar amount to Euros using the current currency exchange rate.
The second transaction involves the recording of a net loss or gain on the transaction due to the exchange rate difference. For example, if the $25,000 equaled 30,000 Euros on the day of the transaction and the $25,000 equals 28,000 Euros when the transaction is finalized, then the company would have gained 2,000 Euros during the exchange.
Recording the Initial Transaction
An accountant must record the initial sale first when accounting foreign currency transactions. For example, if a U.S. company purchases 5,000 Mexican pesos of avocados, and 5,000 pesos equals $500 at the time of the initial sale, then an accountant would record $500 in both accounts payable and purchases.
Recording a Foreign Currency Exchange Gain
An accountant should record a gain if the foreign exchange rate changes in the company’s favor. In the previous example, if 5,000 Mexican pesos now equals $450, then an accountant must debit $500 from accounts payable, credit $450 in cash, and credit $50 as a foreign exchange gain.
Recording a Foreign Currency Exchange Loss
An accountant should record a loss if the foreign currency exchange rate changes unfavorably against the company. For example, if the 5,000 pesos in the previous example now equals $550, then an accountant would debit $500 from accounts payable, credit $550 in cash, and debit $50 as a foreign exchange loss.
Gains and losses on transactions must be reported when the transaction is finalized and at the end of each accounting period. For instance, if a transaction involving a foreign currency exchange is entered on 6/1/2013 and the company pays for the transaction on 7/31/2013, then the transaction must be revalued on June 1st and July 31st.
It may seem complicated at first, but it really does come down to common sense and practical accounting procedures. By following this guide, companies will be able to effectively balance their books and have accurate records of all of their foreign business transactions.
This post was supplied by the team at Business Results Accountants in Brisbane. If you'd like to know more about accounting for your money making schemes online or offline, give them a call.