The Accounting Problem of the Foreign Branch
From the viewpoint of accounting, the only problem in connection with foreign branches which differs from those of domestic branches concerns the conversion of the foreign currency—in terms of which the records of the foreign branch are kept—into the currency of the head office. Periodically—usually at the close of the fiscal period—the results as shown by the branch records must be incorporated with those of the head office. The problem involved is for the most part due to the fact that, while the activities of the various branches have been transacted and recorded in terms of one or more currencies, the net results of those activities are to be taken effect of, usually as a disbursement of dividends, in the terms of the head office currency. That is, earnings are made and expenses incurred in one currency, and the net result of the branch’s trading must be disbursed in terms of another currency. The fluctuations in exchange prevailing throughout the year at the time of the various transactions of the branch and at the time when the net results of the branch are disbursed as dividends from the head office, sometimes give rise to a very complicated problem if accurate and satisfactory results are to be secured.
It is impossible, from the standpoint of practice, to convert every transaction of the branch into the currency of the head office at the rate prevailing at the time of the transaction; and furthermore, the funds out of which ultimately some portion of the dividends must be paid are, at the close of the fiscal period, still held in the possession of the branch and so are not available except through the process of conversion. Accordingly, the question of the rate of exchange prevailing at the close of the fiscal period has a very important bearing on the correct showing of the branch’s activities on the head office books.
It is not purposed here to go into the question of organization, or method of keeping accounts for the foreign branch. As was stated above in connection with domestic branches, any system of accounts depends very largely upon the general organization of the head office and its branches, and this in turn depends on the degree of control and amount of information desired. The discussion will be limited to the assumption that the branch has an almost independent organization and is expected to make a full report periodically by means, at least, of a trial balance of the branch.
Accounts Opened on Books
On the books of the branch a Head Office Control or Adjustment account will be carried which represents the ownership of the head office in the branch; and on the head office books a Branch Control or Adjustment account which is the complement of the head office account on the branch books. Frequently, in addition to these interrelated accounts, a Remittance account is carried for the purpose of facilitating reference. In this account are entered the remittances made by the branch to the head office, instead of entering such transactions in the Head Office Control account. The problem to be discussed here concerns the method of converting the branch trial balance before incorporating it, and the root of the problem lies in the determination of the basis for the conversion of the various kinds of items listed therein. Fixed and current asset and liability items, expense and income items, the Head Office Control and Remittance accounts—all must be converted. For an accurate and equitable showing of the branch activities on the head office books under certain conditions, these different classes of items should not be converted at the same rate. Under other conditions no serious inequity results from the use of a uniform rate of exchange for the conversion of all items, and in practice such a rate is handled much more simply than different rates. Of course, the branch trial balance is in balance previous to conversion but is almost invariably out of balance after conversion. It becomes necessary, therefore, to take up the difference by means of a debit or credit to an account called “Exchange” or “Fluctuations in Exchange”—sometimes also called “Reserve for Fluctuations in Exchange.”
Handling Fluctuations in Foreign Exchange
The proper handling and ultimate disposition of this Exchange or Fluctuations in Exchange account requires some consideration. If there is a loss in the conversion of the branch trial balance into the head office currency, that may be treated as a current expense to be charged ultimately to the current period’s profit and loss. Any profit accruing from the same source may be similarly handled. Some concerns set aside all profits accruing in this manner into a Reserve for Fluctuations in Exchange account, against which are charged any losses incurred through conversion. If the first period shows a loss on conversion, it would, of course, be necessary to reserve out of that period’s profits a sufficient amount to take care of the loss. Usually, however, the items of profits and losses on conversion of exchange counterbalance each other fairly well throughout succeeding periods. The item is for the most part comparatively small and either method of handling it is satisfactory and gives sufficiently correct results under normal conditions but often too inaccurate under abnormal conditions.
Conversion of Branch Results
The basis on which the closing entries are converted from the foreign to the local currency is a very important factor. If the ratio between the two countries is more or less stable, an average rate may be adopted without much variation in the established values. All profits or losses on exchange resulting from differences between actual rates on current transactions and this average rate will be entered in the Fluctuations in Exchange account. However, in periods of rapidly fluctuating rates of exchange, or in transactions with branches where silver currency or depreciated paper or non-guaranteed currency are in use, the conversion of all items at some arbitrary or average rate will not give accurate or satisfactory results. In such cases certain practices have been established as being the most equitable in converting the various accounts of the branch balance sheet into the local currency for the purpose of amalgamating them into the home office balance sheet. These practices are summed up as follows: