First convert the foreign currency into dollars at the following rates:
1. Fixed assets at the same rate as before, that is, the rate at the time of purchase, or average rate for the purchases of a fiscal period. The reason for this is that fluctuations in the value of fixed assets, whether expressed in one currency or another, are not allowed to affect the period’s results.
2. Floating assets and liabilities at the rate current as of the date of the balance sheet.
3. Revenue items at an average rate for the period.
4. Remittances at the actual rates paid.
5. Control or adjustment account at the same rate as that which had been established on the head office books at the last period.
To arrive at the average rate in the case of fixed assets it is sufficient to take the rate prevailing at the end of each month throughout the year and divide the total by twelve. This becomes necessary where construction or purchases of fixed properties take place throughout the year. The difference, if the rate is less than par, is credited to the capital expenditure and debited to Profit and Loss on the head office books. The branch is notified of the adjustment and makes a similar entry crediting Exchange and debiting the head office with the amount.
Current assets and liabilities are converted at the rates current at the date of the balance sheet because the balance sheet should represent these values at the exact cost of converting them into cash at the present moment. If in practice they were actually liquidated, this could not be realized but in principle it represents the present condition. Revenue items are convertible at the average rate because they represent items accumulating during the entire fiscal period; they represent the result of the business activities for the past period, at varying rates of exchange. Since the remittance account represents the actual cash paid for cash transmitted, there is no occasion for changing the rate which has been used at various times during the period. The Control or Adjustment account likewise was converted at the time the entries were made to it and represents the exact cost of the various transactions recorded in it.
After all balance sheet items have been converted according to the rates prescribed, it is a general custom to provide a reserve account to cover any losses on exchange not provided in the conversion of the accounts. This is done for the purpose of guarding against overstating values and thus paying dividends out of the capital, since the conversion into head office currency merely serves as a medium of estimating what the foreign investment really represents to the stockholders.
An illustrative problem is given below with its solution based on the principles of conversion just stated. It is to be noted that in practice, within the limitation stated on page 546, a uniform rate of conversion is generally made use of for all items except remittances, for which the actual rate is used.