Accounting for corporate finance: foreign exchange: foreign operations: closing rate/net investment method: when to use
When should a company use the closing rate/net investment method?
In many cases a foreign operation will carry on its own trade or business. While the UK company will exercise normal oversight, and there may be some trading or financing transactions between the reporting entity and the foreign operation; the foreign operation will often operate relatively independently of the reporting entity. It may borrow locally to finance the purchase of assets, or to provide working capital. Its profits are not influenced to any significant extent by exchange movements between its local currency and sterling. As a result, it is likely that the foreign operation will have a functional currency (or local currency if applying SSAP 20 under Old UK GAAP) different to that of the rest of the company.
The reporting entity will, in these circumstances, use the closing rate/net investment method to translate the results of the foreign operation. This reflects the economic reality. The reporting entity is not particularly interested in what the individual assets and liabilities of the foreign operation are worth at the balance sheet date - it is more concerned with the value of its net investment.
Similarly, if the reporting entity wants to know how valuable the foreign operation is to the group, the best indicator is the local currency profits of the subsidiary. Under the closing rate/net investment method, the only amount taken to the consolidated profit and loss account (or income statement) is the sterling equivalent of the foreign operation’s overall profit. Exchange differences arising on translation of the reporting entity’s investment go to reserves (as other comprehensive income). This is justified as such exchange differences aren’t related to the foreign operation’s trading or financial performance, and would distort the picture presented by the accounts if they were included in the profit and loss account (or income statement).
In cases where foreign operations do not have such independence, and instead act as an extension of the reporting entity, such foreign operations should typically adopt the same functional currency as the rest of the company. This has the same practical effect as using the temporal method under SSAP 20 (see CFM26270).