CFM8028 – Accounting for foreign exchange: when to use the closing rate/net investment method

When should a company use the closing rate/net investment method?

In many cases a foreign subsidiary (or other foreign enterprise in which a UK company has an equity stake) will carry on its own trade or business. While the UK parent will exercise normal shareholder oversight, and there may be some trading or financing transactions between parent and subsidiary, the subsidiary will operate relatively independently of the parent company. 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.

The UK company will, in these circumstances, use the closing rate/net investment method to translate the results of the subsidiary. This reflects the economic reality. The parent company is not particularly interested in what the individual assets and liabilities of the subsidiary are worth at the balance sheet date – it is more concerned with the value of its net investment.

Similarly, if the parent company (or the user of group accounts) wants to know how valuable the subsidiary 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 is the sterling equivalent of the subsidiary’s overall profit. Exchange differences arising on translation of the parent company’s investment go to reserves. SSAP20 justifies this by saying that such exchange differences aren’t related to the subsidiary’s trading or financial performance, and would distort the picture presented by the accounts if they were included in the profit and loss account.