CFM26250 - Accounting for corporate finance: foreign exchange: foreign operations: closing rate/net investment method: example

A UK company has a US branch which it set up many years ago when the exchange rate was £1 = $2. It is preparing accounts for the year ended 31 December 20X4. Exchange rates are as follows:

31 December 20X3: £1 = $1.60

31 December 20X4: £1 = $1.20

It translates the profit and loss account of the foreign operation at the closing rate. The profit and loss account of the foreign operation, in US dollars and translated into sterling, is

— $ Rate £
Profit on ordinary activities before taxation 130,000 1.2 108,333
Taxation - 40,000 1.2 33,333
Profit after taxation 90,000 1.2 75,000

The opening and closing balance sheets, in US dollars and in sterling, are as follows:

— 31/12/X3 — 31/12/X3 31/12/X4 — 31/12/X4
— $ Rate £ $ Rate £
Fixed assets 80,000 1.6 50,000 90,000 1.2 75,000
Current assets 30,000 1.6 18,750 95,000 1.2 79,167
Current liabilities - 45,000 1.6 - 28,125 - 30,000 1.2 - 25,000
Long-term loan - 15,000 1.6 - 9,375 - 15,000 1.2 - 12,500
Net assets 50,000 1.6 31,250 140,000 1.2 116,667
Branch capital 1,000 2.0 (note 1) 500 1,000 2.0 (note 1) 500
Retained profits 49,000 (note 2) 30,750 139,000 (note 2) 116,167
— 50,000 — 31,250 140,000 — 116,667

Note 1: The company’s original investment in its foreign operation is carried at historic cost.

Note 2: Retained profits are the balancing figure.

The sterling figure for retained profits at 31 December 2004 can be analysed as follows:

— £
Balance b/f 30,750
Profit for year 75,000
Exchange gain 10,417
Total 116,167

The exchange gain of £10,417 arises on retranslation of the opening net assets from the opening to the closing rate:

— £
$50,000 at £1 = $1.6 £31,250
$50,000 at £1 = $1.2 £41,667
Exchange gain £10,417

The exchange gain is taken to reserves as an item of other comprehensive income (OCI). In the reporting entity’s accounts, the Statement of Comprehensive Income will contain the following entry (under Old UK GAAP this will be recognised in the Statement of Total Recognised Gains and Losses (STRGL)):

Currency translation differences on foreign currency net investment: £10,417

What will happen if the company translates the profit or loss of the foreign operation at an average rate for the year - say £1 = $1.5? (Note this is the only option for companies adopting FRS 23,IFRS and New UK GAAP).

The sterling equivalent of the $90,000 profit becomes £60,000. The difference between this amount and the £75,000 resulting from translation at the closing rate, i.e. an exchange gain of £15,000, would be taken to reserves (OCI). The analysis of retained profit at 31 December 2004 becomes:

— £
Balance b/f 30,750
Profit for year 60,000
Exchange gain 25,417
Retained profits 116,167