CFM8026a – Accounting for foreign exchange: exchange differences and the closing rate/net investment method
Closing rate/net investment method: exchange differences
How do exchange differences arise when the closing rate/net
investment method is used?
A parent company's net investment in a subsidiary at the end
of an accounting period will be its net investment at the beginning
of the period, plus the profit made by the subsidiary 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, 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 to translate profits, a further exchange difference arising from retranslating profits from the average to the closing rate.
The example at CFM8026b illustrates this.
