CFM26240 - Accounting for corporate finance: foreign exchange: foreign operations: closing rate/net investment method: exchange differences

How do exchange differences arise when the closing rate/net investment method is used?

A reporting entity’s net investment in a foreign operation at the end of an accounting period will be its net investment at the beginning of the period, plus the profit made by the foreign operation in the period. This can be expressed by saying:

opening net assets + profit = closing net assets

So if you:

• translate the opening net assets at the closing rate of exchange,
• add in the profit for the year, also translated at the closing rate,

you will get

• the closing net assets, translated at the closing rate.

The opening net assets will have been translated at last year’s closing rate in the previous year’s balance sheet. So an exchange difference will arise when they are retranslated:

(Opening net assets translated at opening rate + exchange difference) + (profit translated at closing rate) = (closing net assets translated at closing rate)

If the company translates the subsidiary’s profit at an average rate of exchange (or transaction rate), rather than at the closing rate, you need to include a further exchange gain or loss in order to make the equation balance:

(Opening net assets translated at opening rate + exchange difference) + (profit translated at the average rate for the period + exchange difference) = (closing net assets translated at closing rate)

Thus the exchange gain or loss arising on consolidation may have two components:

• an exchange difference arising on retranslating the opening net assets from the opening rate to the closing rate, and
• if the company uses an average rate (or transaction rate) to translate profits, a further exchange difference arising from retranslating profits from the average to the closing rate.