CFM7050 - Understanding foreign exchange: keeping records

Accounts in foreign currencies

A business' profit or loss will be affected by the currency in which it draws up its accounts. A very simple example will illustrate this.

Imagine that a trader has £100. He travels to France, where he converts the £100 into euros at a time when the exchange rate is €1.65/£. He receives €165, which he uses to buy goods. Some time later, he sells those goods for €200, and changes the proceeds back into sterling. The exchange rate is now €1.61/£, so he receives £124.

How much profit has he made? If he draws up an account in sterling, it will show a profit of £24 (£124 - £100). But if he draws up an account in euros, he has made a profit of €35 (€200 - €165). If he translates this profit into sterling at the exchange rate prevailing at the end of his business venture, €1.61/£, he has made a profit of only £21.74.

The difference is that, if he accounts in sterling, his accounts will reflect the exchange gain he has realised because sterling has weakened against the euro. If he accounts in euros, they will not.

A company which carries on a UK trade, but also makes sales and purchases in euros (or some other foreign currency) would normally keep its financial records in sterling. Sterling is its functional currency (or local currency, to use an earlier term) – the currency of its main economic environment. If it recorded all of its transactions in euros, they would not fairly reflect its foreign exchange exposure.

In the majority of cases, the currency in which a company presents its accounts (its presentation currency) will be its functional currency. Under SSAP 20, the accounting standard in use for periods beginning before 1 January 2005, this was assumed always to be the case. However, for later periods, you may see accounts presented in some other currency – for example, a UK company may be required to present its accounts in the currency of its ultimate parent company.

You may also see accounts of a UK resident company that does not have sterling as a functional currency.. The most common circumstances are:

• The company is engaged in a business where it is normal for all transactions to be denominated in a non-sterling currency. For example, a shipping company, although incorporated and resident in the UK, might prepare accounts in US dollars, because its business is conducted almost entirely in dollars.
• The company's business is conducted almost entirely abroad, so it has no real exposure to fluctuations in the value of sterling.
• The company is incorporated abroad, and draws up accounts in the currency of the territory in which it is incorporated, but it is resident in the UK for tax purposes because its top tier of management is located here.

There are special tax rules for companies that prepare accounts in a non-sterling currency. See CFM10500+.