FOREIGN BRANCH INTRODUCTION
Introduction
A head office may set up a branch in another country as part of its expansion policy. The currency of the foreign branch may differ from that of the head office. Thus it will be necessary to translate the results and financial position of the foreign branch into the head office currency prior to its inclusion with the head office’s results and financial position.
International Accounting Standard 21, the Effects of Changes in Foreign Exchange Rates provides guidance on the translation of a foreign branch.
The principal issues are which exchange rate(s) to use and how to report the effects of changes in exchange rates in the financial statements.
IAS 21 distinguishes between the functional currency and the presentation currency.
The functional currency is the currency of the primary economic environment in which the entity operates. The presentation currency is the currency in which the financial statements are presented.
Functional Currency
An entity considers the following facts in determining its functional currency:
- The currency that mainly influences sales prices for goods and services and of the country whose competitive forces and regulations that mainly determine these selling prices.
- The currency that mainly influences labour, material and other costs.
In both cases this often will be the currency in which prices and costs are denominated and settled.
The following factors may also provide evidence of an entity’s functional currency:
- The currency in which funds from financing activities are generated i.e. issue of shares/debt.
- The currency in which receipts from operating activities are retained.
The following additional factors are considered in determining the functional currency of a foreign operation:
- Whether the activities of the foreign operation are carried out as an extension of the reporting entity rather than being carried out with a significant degree of autonomy.
- Whether transactions with the reporting entity are a high/low proportion of the foreign operation’s activities.
- Whether cash flows of the foreign operation’s activities affect the cash flows of the reporting entity and are readily available for remittance to it.
- Whether cash flows of the foreign operation’s activities are sufficient to pay existing debt obligations without funds being made available by the reporting entity.
TRANSLATION RULES
Where the operation of the foreign branch is an integral part of the head office’s business the following translation rules should be followed:
Statement of Financial Position
Non-Current Assets
-
- The rate ruling when the head office provided the funds for the purchase of the assets or
- If the branch purchased the asset itself, the rate at the date of purchase.
Closing Inventory
-
- If acquired from the head office the actual rate is used
- If purchased locally the rate at date acquired
Current Assets and Liabilities Excluding Inventory
The rate of exchange prevailing on the Statement of Financial Position date, often referred to as the closing rate.
Head Office Account
This item is not translated but the RWF amount of “BRANCH CURRENT ACCOUNT” in head office books is substituted. Care must be taken to see that items in transit have been adjusted for before the substitution takes place.
Remittances
These are always converted at the actual rate of exchange.
Income Statement
Income and expenses except for opening inventory, purchases, closing inventory and depreciation should be translated at the average exchange rate for the period.
Opening Inventory/Purchases/Closing Inventory
- If acquired from the head office the actual rate is used
- If acquired locally the purchases should be translated using the average rate for the year whilst opening and closing inventory should be translated using the rate at the date acquired. Often for opening and closing inventory the rate may be an average for the period over which the inventory was acquired.
Depreciation
The conversion must be at the rate applied to the relevant tangible non-current asset.
Treatment of Difference in Exchange
This is a RWF amount found on the imbalance of the converted trial balance. It indicates that the head office figure of branch current account is either too great (loss on exchange) or too little (gain on exchange). An entry is consequently made in the head office books:
Debit Income Statement
Credit Branch Current Account
A loss on exchange
or
Debit Branch Current Account
Credit Income Statement
A gain on exchange
This method of translation is often referred to as the “Temporal Method”.
Situations where the temporal method is appropriate are:
- Where the branch acts as a selling agent receiving stocks of goods from the head office, selling them in local currency and remitting the proceeds back to the head office;
- Where the branch produces a raw material or manufactures parts or subassemblies which are then shipped to the head office for inclusion in its own products;
- Where the branch is located “overseas” for tax, exchange control or similar reasons to act as a means of raising finance.
THE CLOSING RATE METHOD
The closing rate method of translation is used when the foreign branch is regarded as an investment by the head office. Head office does not trade with the branch, the branch is essentially an independent unit.
Translation Rules – Statement of Financial Position
All items, non-current assets, inventory, trade receivables, trade payables, etc. are translated at the year-end rate except the head office current account. The head office current account is not translated but the RWF amount of “BRANCH CURRENT ACCOUNT” as in head office books is substituted. Care must be taken to ensure that items in transit have been adjusted before the substitution takes place.
Translation Rules – Income Statement
The income and expenses are translated at the average rate for the period.
Treatment of Difference in Exchange
This is a RWF amount found on the imbalance of the converted trial balance. The gain or loss on exchange is brought directly to equity, it is presented in the statement of changes in equity.
FOREIGN CURRENCY TRANSACTIONS
When an enterprise enters into a foreign currency transaction, which is settled immediately, the accounting entries are:
Debit Asset/Expense Account
Credit Bank Account
However, if the transaction is not settled, an exchange gain or loss may arise if the exchange rate changes between the date of the transaction and the date the transaction is settled i.e. paid for/money received. The accounting treatment of the exchange loss/gain is to debit/credit it and to recognise it in the income statement of the period in which it arises. The rationale behind this accounting treatment is that the management have decided to take credit/extend credit in a foreign currency and the effects of this decision should be reflected in measuring their performance.
Reporting at Subsequent Statement of Financial Position Dates
At each Statement of Financial Position date foreign currency
- Monetary items e.g. trade receivables shall be translated using the closing rate i.e. the rate at the Statement of Financial Position date;
- Non-monetary items e.g. tangible assets that are measured at historical cost shall be translated using the exchange rate at the date of the transaction and
- Non-monetary items measured at fair value shall be translated using the exchange rates at the date the fair value was determined.
Recognition of Exchange Differences
Exchange differences arising on the settlement of monetary items or on the retranslation of monetary items shall be recognised in the income statement in the period in which they arise.
