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HMRC internal manual

Corporate Finance Manual

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HM Revenue & Customs
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Accounting for corporate finance: foreign exchange: foreign operations: temporal method: example

The facts are the same as in the example at CFM26250. The UK company set up the US branch many years ago when the exchange rate was £1 = $2. It is preparing the reporting entity’s accounts for year ended 31 December 2004, and relevant exchange rates are:

31 December 2003: £1 = $1.6

31 December 2004: £1 = $1.2

Average rate for year: £1 = $1.5

Because it is necessary to translate non-monetary items at the historical rate, additional information about the fixed assets is needed. Assume they were purchased in two tranches:

Date of acquisition 1 January 1999 1 July 2004
     
Exchange rate at acquisition date £1 = $1.66 £1 = $1.80
Book value at 31/12/2003 $80,000  
Additions at cost   $62,700
Depreciation for year $48,000 $4,700
Book value at 31/12/2004 $32,000 $58,000

The foreign operation had no stock at either 31 December 2003 or 31 December 2004. (Stock is also a non-monetary asset - if the foreign operation had stocks in its balance sheet, they would also need to be translated at the historical rate. In practice, an average rate would be used for the period over which the stocks were acquired.)

When the temporal method is used, the translation of the profit and loss account is as follows:

  $ Rate £
       
Profit before depreciation 182,700 1.5 121,800
Depreciation (52,700) 1.66/1.8 31,527
Profit on ordinary activities before taxation 130,000   90,273
Exchange difference     117
Taxation ( 40,000) 1.5 (26,667)
       
Profit after taxation ( 90,000)   63,723

Strictly, individual transactions should be translated at the rate for the day on which they took place, but companies will normally use an average rate as an approximation.

Depreciation is translated at the historical rate proper to the asset concerned.

The exchange difference is the balancing figure.

The sterling profit figure is obtained from the translation of the balance sheet - see below.

Translating the balance sheet gives:

  31/12/03   31/12/03 31/12/04   31/12/04
             
  $ Rate £ $ Rate £
Fixed assets 80,000 1.66 48,193 90,000 1.66/1.8 51,499
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   29,443 140,000   93,166
Branch capital 1,000 2.0 500 1,000 2.0 500
Retained profits 49,000   28,943 139,000   92,666
  50,000   29,443 140,000   93,166

The difference between retained profits at 31 December 2004, £92,666, and retained profits at 31 December 2003, £28,943, gives the profit for the year £63,723 that is shown in the profit and loss account above.

FRS 23 under Old UK GAAP, IFRS and New UK GAAP

Under FRS 23, IFRS and New UK GAAP, a foreign operation with no real operational independence from its parent (such as one which falls to be accounted for using the temporal method under SSAP 20), should adopt the same functional currency as its parent. Therefore, in this example, the US branch would adopt sterling as its functional currency and translate its dollar assets and liabilities in the same way as set out above, but in its own financial statements. In the reporting entity’s accounts, this would have the same practical effect as adopting the temporal method under SSAP 20.