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METHODS OF ACCOUNTING FOR EXCHANGE OPERATIONS.

1. It would be difficult to ascertain what methods of conversion are most commonly used by international enterprises. It is safe to say, however, that the methods are varied, and that some of them are designed to eliminate book-keeping detail rather than to produce an accurate figure for the gain or loss on exchange. By keeping reciprocal accounts on the home office books or by other methods,1 the necessity for converting some or even all of the items on branch trial balances may be avoided. Accounting texts2 usually state, however, that the accounts appearing in branch trial balances should be converted somewhat as follows:

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2. Since many factors are involved in the determination of exchange losses and gains, a consideration of underlying assumptions is essential before any intelligent analysis of the problem can be made. In determining the income assignable to the home office of an enterprise for tax purposes either of two methods may be used. The total income of the enterprise may be determined by consolidating the figures for all branches throughout the world, and the income assignable to the home office may then be obtained by deducting from this total the amount of income allocable to foreign branches. Or the income of the home office may be determined on the assumption that it is simply another branch whose income is to be computed on the basis of its own accounts as a separate business unit. This assumption implies that the relationships between the home office and other branches are to be essentially the same as the relationships between a parent company and its wholly owned subsidiaries. The results shown by the two methods are likely to be quite different, and the choice of method therefore constitutes an important question of policy. Accounting methods for determining exchange losses and gains under either method are available, but if the utmost confusion is to be avoided it is essential that one or the other be definitely adopted.

3. Business concerns generally seem to proceed on the first assumption — namely, that the profits of foreign branches are to be determined on the basis of their own separate accounts and that all remaining income is to be taken up by the home office. The effect of this procedure is to assign to the home office all exchange losses and gains arising out of the conversion of branch trial balances. From the point of view of the enterprise as a whole, this result is entirely fair. Since exchange gains and losses can be ultimately realised only on actual remittances, they are properly assignable to the home office. The transfer of funds, in other words, is a home office function. The method here outlined for determining home office income and losses and gains on exchange is the one most commonly followed in accounting practice. It is also the method implied by the income-tax law of the United States, which purports to tax the total income of American enterprises but allows a credit for taxes paid on income earned abroad. In view of all these facts, it is probable that foreign exchange gains and losses on inter-branch transactions may be most conveniently handled by assigning them to the home office. This is desirable particularly if the home office hedges its commitments abroad.

4. The conversion of branch cash balances, accounts and notes receivable, and current liabilities at the current rate is unquestionably proper, and the resulting gains or losses are so definite that no special difficulties usually appear. The proper method for converting inventories, however, is not so obvious. Fluctuations in exchange rates may or may not cause compensatory changes in the market value of goods appearing in an inventory, and it is therefore difficult to find a suitable conversion rate. Since conversion at the current rate may sometimes cause a distortion of profit, it is recommended that foreign branch inventories be valued on the consolidated statements of an enterprise at cost or market, whichever is lower in terms of the currency of the home country. It may be assumed, for example, that goods appearing in the inventory of the London branch of an American enterprise cost $4,850 and were recorded on the branch books at a value of £1,000. Converting this amount at a current rate which may be assumed to be $3.50 would give a value of $3,500 and show a loss of $1,350. It is possible, however, that the fall in the value of the pound might have caused the market value of the merchandise in London to rise to £1,200, in which event this amount should be converted at $3.50. As a result the loss on exchange would be reduced from $1,350 to $650 ($4,850—1,200×$3.50=$650) and the inventory would appear at market, $4,200, which is lower than cost. If market were higher than cost, the goods would ordinarily be carried on the consolidated statements at their original cost. $4,850.

5. Another difficult problem arises in connection with the conversion of fixed asset and related depreciation accounts. The situation may be most easily explained by the use of illustrative figures. Suppose an American company invested £10,000 in machinery and equipment for its London branch when sterling exchange was at $4.85. The investment expressed in dollars would then be $48,500, and, if depreciation be figured at 10 per cent, the annual charge would be $4,850 or £1,000. Suppose, however, that sterling exchange falls to $3,50 and remains at approximately that level. The annual depreciation will still be recorded at £1,000 by the branch, but when converted into dollars the amount will be only $3,500. The difference between this $3,500 and the $4,850 decline in the value of the machinery and equipment appears as an exchange loss of $1,350. In other words, one-tenth of the useful life of the machinery has been consumed and only $3,500 of the original cost in dollars has been recovered. Since the branch has already borne the full charge for depreciation stated in pounds sterling, it is clear that the $1,350 exchange adjustment, if recognised at all, must appear as a loss of the home office. It may be argued that this is merely a book loss which has not been realised and which cannot be realised until the funds recovered from the consumption in use or from the sale of the fixed assets are actually remitted. Exchange fluctuations, moreover, may be regarded as temporary and likely to be compensated for by later changes in an opposite direction. Although there is some force in these arguments, it should be noted (1) that a company which fails to recover funds equal in purchasing power to the original cost of assets currently consumed suffers a real economic loss whether it be recognised for tax purposes or not; (2) that it is practically impossible to determine when the recovered costs of fixed assets are remitted; and (3) there is no assurance that exchange gains and losses will balance over a period of years, and, even if they do, the essential difficulty still remains, since taxes are paid on the profits of separate years and not on the total profit of a number of years.

6. The problem which arises in connection with the conversion of fixed assets, depreciation reserves, and annual depreciation charges is sometimes solved in practice by the following procedure. At the date of acquisition, fixed assets are recorded on the branch books at their cost in the currency of the country in which the branch is located and on the home office books in the currency of the home country. Thereafter, depreciation is computed and recorded independently on the two sets of books, and no attempt to reconcile the annual charges or the carrying values in the different currencies is made. When the assets are sold or scrapped, the gain or loss to the branch is determined on the basis of its accounts according to the rules applicable to independent concerns. Thus, branch depreciation allowances and gain or loss on sales of fixed assets are correct from the point of view of the country in which the branch is located. The proceeds arising from the sale of the fixed assets are then converted into the currency of the home country at the prevailing rate and the gain or loss taken up on the basis of the home office accounts. As a result of this procedure it would be entirely possible for a gain to be shown in one country and a loss in the other on the same transaction: but both tax administrations should be satisfied, since the books of both home office and branch are kept according to the rules and regulations of their respective countries. This method, it should be noted, is equivalent to converting assets and expenses in the customary way1 and assigning the gain or loss on exchange to the home office. Under one method the gain or loss on exchange appears as a separate item, under the other it is concealed in the general profit-and-loss account. If losses and gains on exchange are to be recognised as deductions from or additions to the taxable income of the home office of an enterprise, the practical method of computing depreciation independently in the two currencies may be the most convenient method to follow.

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7. All of the methods of conversion discussed above rest on the assumption that profit is to be determined from the point of view of the whole enterprise. The income attributable to the home office, in other words, is the income of the whole enterprise, as shown by the consolidated statements less the income allocable to foreign branches. It would be equally plausible to determine home office profit on an entirely different basis. It might be assumed that the home office is a branch dealing with other autonomous branches of the enterprise as if they were separate business entities. This, in fact, is the basic assumption of separate accounting. Viewed in this light, foreign exchange losses and gains on inter-branch transactions are determinable by quite different methods.

8. In order to determine such exchange losses and gains directly as they would be determined between independent concerns, it is necessary that a clear distinction be maintained between the permanent capital of a branch and its current debt to the home office. The permanent capital, as indicated by an appropriate resolution of the board of directors, should be recorded as branch capital on the branch books and as an investment in the branch on the home office books. The investment account on the home office books would thus be closely comparable to an account showing the investment in the stock of a wholly owned subsidiary company.

9. In allocating exchange losses and gains on current transactions between a branch and the home office by this method, it is essential that there be a clear indication of the basis on which payment is to be made. An enterprise might reasonably adopt any one of five or six different rules for the settlement of inter-branch charges. It might require:

A sixth method, and it seems to be the typical one, would be to make no rule at all. Settlement of all inter-branch indebtedness in terms of the currency of the home office would assign all current exchange losses and gains to the foreign branches. This would have the advantage of reducing or increasing branch profits to the amount which the home office might reasonably expect to receive if the profits were currently remitted. It is doubtful, however, whether the countries in which branches are located would recognise losses of this character, and it seems rather artificial to assign to branches losses or gains which in any event must ultimately belong to the home office. The second rule requiring settlement in the currency of the branch would, of course, assign current losses and gains on exchange to the home office. This result is desirable for two reasons. It is so clearly a function of the real centre of management to direct the transfer of funds from one country to another that it seems logical to allocate exchange losses and gains in accordance with this responsibility. Moreover, if an enterprise follows the policy of hedging its foreign exchange commitments, the hedging operations are likely to be conducted by the home office, and it is desirable that losses and gains on the actual transactions should appear there also. Under rules three and four, the responsibility for losses and gains is divided between the branches and the home office. Method three might be convenient, but method four is not recommended, because of the confusion which might result if each branch were compelled to do its billing in three or four currencies. Rule five is the most flexible and therefore offers the best opportunity for adapting a system of foreign exchange accounting to the needs of each particular business. Under this rule an arrangement could be made whereby the branch would assume the risk of exchange fluctuations in connection with merchandise transfers — for example, while the home office would assume the risks on financial transactions such as the remittance of profits, interest, and the like; or the opposite arrangement could be made. Although flexibility is highly desirable, it is doubtful whether the benefits in this instance would outweigh the tax difficulties which would arise if each enterprise had a different plan for allocating exchange losses and gains. It would seem more reasonable to adopt a uniform rule such as number two and to permit occasional exceptions where conditions warrant. Irrespective of the currency in which inter-branch charges are originally billed, it would seem to be desirable to have all settlements made on the basis of the branch accounts — that is, at the current rate of exchange at the date of the bill rather than the rate on the date of settlement. In other words, as a general rule, exchange losses and gains should be assigned to the home office.

10. Under the theory that the home office and the foreign branches are autonomous business units dealing with one another as with independent concerns, the gain or loss on exchange shown by the conversion of branch trial balances does not logically enter at all into the determination of home office income. There is, in fact, no need for making these conversions in computing profits earned by the branches or by the home office. Exchange differences, in other words, enter into the profit-and-loss account only when they occur in connection with actual remittances. Losses or gains arising from the conversion of depreciation charges and fixed asset accounts at different rates would not appear at all.

11. Exchange losses and gains on transactions affecting the permanent capital accounts of autonomous branches may be determined by the following procedure. The branch capital account, and conversely the investment account carried at the home office, would ordinarily contain the following items:

Additions:

Deductions:

12. Remittances to or from the branch would properly be recorded on the two sets of books at the amounts actually received or paid in the respective currencies. Reinvested profits and branch losses would be recorded at the rates then current. The exchange gain or loss on a remittance of capital from the branch to the home office might be computed in either of two ways. Branch remittances (other than those on current account already discussed) might be treated as, first, a transfer of profits in the reverse order in which they were earned, and, second, after all profits have been transferred, as a return of capital to the home office in the reverse of the order in which it was invested. The use of this method would be facilitated if the branch were to keep an undivided profits account as well as a capital account. The exchange gain or loss could then be readily determined by comparing the proceeds of the branch remittance with the amount at which the profit or the investment covered by the remittance was originally recorded on the home office books. A simpler method would be to convert the remittance at a rate obtained by dividing the investment account at the home office by the branch capital account and to compare the result with the actual proceeds of the remittance. The methods here suggested are not as complicated as this condensed description of them might indicate. In effect, they treat branches practically as wholly owned subsidiaries. No loss or gain on exchange is shown unless actual remittances are made.

13. To summarise, two general methods for the determination and allocation of exchange losses and gains have been outlined:

14. Making a choice between these methods is not easy. The latter is more in harmony with the fundamental concept of separate accounting, and it prevents the recognition of gains or losses not actually realised. It is based on accounting methods, however, which are not generally used. The first method, on the other hand, is regularly used by business enterprises in their own accounting, and it produces reasonable results. In view of these conditions it is suggested that the first method be accepted for the majority of taxpayers, but that the second method, if consistently followed, be recognised in the case of enterprises which have placed their branches on a capitalised basis and which keep accounts from which exchange losses or gains can be directly determined. Under either method, it is recommended that exchange losses and gains be generally allocated to the home office.

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