IAS 21 – THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES
The objective of this Standard is to prescribe how to include foreign currency transactions and foreign operations in the financial statements of an entity and how to translate financial statements into a presentation currency.
This Standard shall be applied:
- In accounting for transactions and balances in foreign currencies, except for those derivative transactions and balances that are within the scope of IFRS 9 Financial Instruments;
- In translating the results and financial position of foreign operations that are included in the financial statements of the entity by consolidation, proportionate consolidation or the equity method; and (c) In translating an entity‘s results and financial position into a presentation currency.
The following terms are used in this Standard with the meanings specified:
Closing rate is the spot exchange rate at the end of the reporting period.
Exchange difference is the difference resulting from translating a given number of units of one currency into another currency at different exchange rates. Exchange rate is the ratio of exchange for two currencies.
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
Foreign currency is a currency other than the functional currency of the entity.
Foreign operation is an entity that is a subsidiary, associate, joint venture or branch of a reporting entity, the activities of which are based or conducted in a country or currency other than those of the reporting entity.
Functional currency is the currency of the primary economic environment in which the entity operates.
A group is a parent and all its subsidiaries.
Monetary items are units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency.
Net investment in a foreign operation is the amount of the reporting entity‘s interest in the net assets of that operation.
Presentation currency is the currency in which the financial statements are presented. Spot exchange rate is the exchange rate for immediate delivery.
INDICATORS OF FUNCTIONAL CURRENCY
Primary economic indicators
The primary economic environment in which an entity operates is normally the one in which it primarily generates and expends cash. An entity considers the following factors 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 mainly determine the sales prices of its goods and services.
- The currency that mainly influences labour, material and other costs of providing goods or services
The following factors may also provide evidence of an entity‘s functional currency (judgements from management if functional currency is not immediately):
- The currency in which funds from financing activities (i.e. issuing debt and equity instruments) are generated.
- The currency in which receipts from operating activities are usually retained.
Functional Currency of Foreign Operations
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 or a low proportion of the foreign operation‘s activities.
- Whether cash flows from the activities of the foreign operation directly affect the cash flows of the reporting entity and are readily available for remittance to it.
- whether cash flows from the activities of the foreign operation are sufficient to service existing and normally expected debt obligations without funds being made available by the reporting entity
Change in Functional Currency
Once determined, the functional currency is not changed unless there is a change in those underlying transactions, events and conditions.
Currency of Hyperinflationary Economies
If the functional currency is the currency of a hyperinflationary economy, the entity‘s financial statements are restated in accordance with IAS 29 Financial Reporting in Hyperinflationary Economies.
REPORTING FOREIGN CURRENCY TRANSACTIONS IN THE FUNCTIONAL CURRENCY
A foreign currency transaction is a transaction that is denominated or requires settlement in a foreign currency, including transactions arising when an entity:
- Buys or sells goods or services whose price is denominated in a foreign currency;
- Borrows or lends funds when the amounts payable or receivable are denominated in a foreign currency; or
- Otherwise acquires or disposes of assets, or incurs or settles liabilities, denominated in a foreign currency.
A foreign currency transaction shall be recorded, on initial recognition in the functional currency, by applying to the foreign currency amount the spot exchange rate between the functional currency and the foreign currency at the date of the transaction.
A foreign currency transaction may give rise to assets or liabilities that are denominated in a foreign currency. These assets and liabilities will need to be translated into the entity’s functional currency at each reporting date. How they will be translated depends on whether the assets or liabilities are monetary or non-monetary items.
The essential feature of a monetary item, as the definition implies, is the right to receive (or an obligation to deliver) a fixed or determinable number of units of currency. Examples of monetary assets include:
- Cash and bank balances
- Trade receivables and payables
- Loan receivables and payables
- Foreign currency bonds held as available for sale
- Foreign currency bonds held to maturity
- Pensions and other employee benefits to be paid in cash
- Provisions that are to be settled in cash
- Cash dividends that are recognised as a liability
- A contract to receive (or deliver) a variable number of the entity’s own equity instruments or a variable amount of assets in which the fair value to be received (or delivered) equals a fixed or determinable number of units of currency
Foreign currency monetary items outstanding at the end of the reporting date shall be translated using the closing rate. The difference between this amount and the previous carrying amount in functional currency is an exchange gain or loss.
A non-monetary item does not give the right to receive or create the obligation to deliver a fixed or determinable number of units of currency. Examples of non-monetary items include:
- Amounts prepaid for goods and services (e.g. prepaid rent)
- Intangible assets
- Property, plant and equipment
- Provisions to be settled by the delivery of a non-monetary asset
- Equity instruments that are held as available for sale financial assets
- Equity investments in subsidiaries, associates or joint ventures
Non-monetary items carried at historic cost are translated using the exchange rate at the date of the transaction when the asset arose (historical rate). They are not subsequently retranslated in the individual financial statements of the entity.
Issues in the measurement of non-monetary assets
- Subsequent depreciation should be translated on the same basis as the asset to which it relates, so the rate at the date of acquisition for assets carried at cost and at the rate at the last valuation date for assets carried at revalued amounts. Application of the depreciation method to the translated amount will achieve this.
- The carrying amount of inventories is the lower of cost and net realisable value in accordance with IAS 2 The carrying amount in the functional currency is determined by comparing:
- The cost, translated at the exchange rate at the date when that amount was determined.
- The net realisable value, translated at the exchange rate at the date when that value was determined (e.g. the closing date at the reporting date).
Impairment testing of foreign currency non-monetary assets
Similarly in accordance with IAS 36 Impairment 0/ Assets, the carrying amount of an asset for which there is an indication of impairment, is the lower of:
- The carrying amount, translated at the exchange rate at the date when that amount was determined.
- The recoverable amount, translated at the exchange rate at the date when that value was determined (e.g. the closing rate at the reporting date).
The effect of this comparison may be that an impairment loss is recognised in the functional currency but would not be recognised in the foreign currency or vice versa.
The rules in IAS 21 for reporting assets and liabilities at the end of a subsequent reporting period make a distinction between:
- Monetary items, such as trade payables and trade receivables, and Non-monetary items, such as non-current assets and inventory.
The rules are as follows, for entities preparing their individual financial statements:
Asset or liability Accounting treatment for the statement of
|Monetary items||Re-translate at the closing rate.|
|Non-monetary items carried at||No re-translation. The transaction is left at the|
|cost||original spot rate.|
|Non-monetary items carried at||Re-translate at the exchange rate ruling at the|
|fair value||date of the fair value adjustment.|
Recognition of Exchange Differences
Exchange differences arising on the settlement of monetary items or on translating monetary items at rates different from those at which they were translated on initial recognition during the period or in previous financial statements shall be recognised in profit or loss in the period in which they arise, except as described below
There are two situations to consider.
- The transaction is settled in the same period as that in which it occurred: all the exchange difference is recognised in that period.
- The transaction is settled in a subsequent accounting period: the exchange difference recognised in each intervening period up to the period of settlement is determined by the change in exchange rates during that period.
When a gain or loss on a non-monetary item is recognised in other comprehensive income, any exchange component of that gain or loss shall be recognised in other comprehensive income. Conversely, when a gain or loss on a non-monetary item is recognised in profit or loss, any exchange component of that gain or loss shall be recognised in profit or loss.
Exchange differences arising on a monetary item that forms part of a reporting entity‘s net investment in a foreign operation shall be recognised in profit or loss in the separate financial statements of the reporting entity or the individual financial statements of the foreign operation, as appropriate.
In the financial statements that include the foreign operation and the reporting entity (e.g. consolidated financial statements when the foreign operation is a subsidiary), such exchange differences shall be recognised initially in other comprehensive income and reclassified from equity to profit or loss on disposal of the net investment.
Change in functional currency
When there is a change in an entity‘s functional currency, the entity shall apply the translation procedures applicable to the new functional currency prospectively from the date of the change.
The foreign operation: accounting rules
Three stages in the consolidation process:
- The translation stage
- The consolidation stage
The Foreign Operation: Accounting Rules
Three stages in the consolidation process
If a company has a foreign operation (such as a foreign subsidiary) that prepares its accounts in a functional currency that is different from the group’s presentation currency, there are three stages in the accounting process, for the purpose of preparing consolidated financial statements (or including the foreign associate or joint venture in the financial statements of the reporting entity).
Adjust and update Ensure that the individual financial statements of the foreign entity is
|correct and up-to-date.|
|||If any adjustments are required to correct the financial statements of the foreign entity, these should be made in the statements of the foreign entity and in its own functional currency.|
|Translate||||The assets and liabilities of the foreign entity should be translated into the presentation currency of the parent company. (As explained earlier, the presentation currency of the parent company might be the same or might be different from its functional currency.)|
|||The rules for translation are explained below.|
|Consolidate||||After translation, all the financial statements are now in the same currency.|
|||Normal group accounting principles are now used to prepare the consolidated accounts of the group.|
The translation stage
The rules set out below apply where the functional currency of the foreign entity is not a currency suffering from hyperinflation.
The normal rules for translation, contained in IAS 21, are as follows:
- The statement of financial position
- The assets and liabilities of the foreign operation, for inclusion in the consolidated statement of financial position, are translated at the closing rate. (Comparative figures for the previous year are translated at the same rate.)
- For foreign subsidiaries, this rule also applies to purchased goodwill arising on the acquisition of the subsidiary.
- The statement of profit or loss and other comprehensive income
- Income and expenses for inclusion in the consolidated statement of profit or loss and other comprehensive income are translated at the spot rates at the dates of each of the transactions.
- For practical reasons, average rates for a period may be used, if they provide a reasonable approximation of the spot rates when the transactions took place.
- Exchange differences
- All resulting exchange differences are recognised in other comprehensive income for the period and are credited (gain) or debited (loss) to a separate reserve within the equity section of the consolidated statement of financial position, and this reserve is maintained within equity until the foreign operation is eventually disposed of.
- Gains or losses are therefore reported as gains or losses in other comprehensive income and movements in the separate reserve, and not as a gain or loss in profit or loss and an increase or reduction in retained earnings.
The gain or loss on translation
The exchange differences on translation result in a gain or loss. These gains or losses arise from a combination of two factors:
- Income and expense items are translated at the exchange rates ruling during the period, but assets and liabilities are translated at closing rates. The profit is therefore calculated at the actual exchange rates, but the accumulated profit in the consolidated statement of financial position is re-translated at the closing rate.
- The net assets of the subsidiary were translated at last year’s closing rate at the end of the previous financial year. These net assets have now been retranslated and included in this year’s statement of financial position at this year’s closing rate.
IAS 21 states that these differences on translation are not recognised in profit or loss because changes in the exchange rates for these items have little or no effect on cash flows from operations. It would therefore be misleading to include them in profit or loss. However the actual treatment is that the exchange loss should be recognised in other comprehensive income for the year and taken to a separate reserve within equity in the consolidated statement of financial position.
The consolidation stage
After the translation stage, the financial statements of the overseas entity are in the presentation currency of the parent company.
The basic rule is that normal consolidation techniques can now be used. However, foreign exchange reserve must be included in the consolidated statement of financial position for the cumulative exchange differences.
It is also necessary to comply with the requirements of IAS 21 for purchased goodwill and foreign subsidiaries.
Purchased goodwill and foreign subsidiaries
IAS 21 requires that goodwill and any fair value adjustments arising on the acquisition of a foreign subsidiary are to be treated as part of the assets and liabilities of the foreign subsidiary. The rules already described apply to these items.
This means that:
- Goodwill arising on the purchase of the foreign subsidiary (and also any fair value adjustments to the value of assets of the subsidiary) should be stated in the functional currency of the foreign subsidiary.
- The goodwill and fair value adjustments will therefore be translated each year at the closing exchange rate.
A gain or loss on translation will therefore arise (as described above for other assets and liabilities).
The effect of this rule is that goodwill and the acquisition of a foreign operation is re-stated over time because it is re-translated every year at the new closing exchange rate.
Exchange differences in other comprehensive income
Using the method of creating the consolidated statement of financial position shown in the previous example, you do not need to worry about exchange differences. By translating every balance in the subsidiary’s statement of financial position at the closing rate, the exchange differences are automatically included in reserves.
However, you may be asked to calculate exchange differences arising for reporting in other comprehensive income and a separate equity reserve.
The easiest way to work out the exchange differences (excluding the gain or loss on re-translation of goodwill) is to create the accounting equation for the foreign subsidiary in its own currency. Once this is translated into the parent’s currency it will not balance, and the exchange differences are the balancing figure. These are the exchange differences arising from:
- Re-translating the opening net assets of the subsidiary at the closing rate, and Re-translating the subsidiary’s post-acquisition profit at the closing rate.
DISPOSAL OF A FOREIGN SUBSIDIARY
Most of the accounting rules for the disposal of a foreign subsidiary, or for the partial disposal of a foreign subsidiary, are set out in IAS 27 (revised). Disposals are explained in another chapter.
However IAS 27 does not deal with the accounting treatment of the balance on the separate equity reserve account when a foreign subsidiary is disposed of. This matter is dealt with by IAS 21.
- When the entire investment in a foreign subsidiary is disposed of, the cumulative balance in the separate equity reserve (which represents amounts previously recognised in other comprehensive income) should now be reclassified from equity to profit and loss.
- If there was a non-controlling interest in the subsidiary, the NCI is derecognised in the consolidated statement of financial position. Amounts previously recognised in other comprehensive income and attributed to NCI must not be reclassified and recognised in profit or loss of the reporting entity.
- When a proportion of an investment in a foreign subsidiary is disposed of, a proportionate share of the amounts previously recognised in other comprehensive income (the cumulative balance in the separate equity reserve) should now be reclassified from equity to profit or loss.
When income previously recognised as other comprehensive income is reclassified as a gain or loss to profit or loss as a re-classification adjustment, there must be an offsetting loss or gain in other comprehensive income, to avoid double-counting of the gain (or loss).
In other comprehensive income, negative income of $2 million should be recognised, to avoid double counting of the income previously recognised as other comprehensive income but now reclassified in profit or loss.
- The amount of exchange differences recognised in profit or loss (excluding differences arising on financial instruments measured at fair value through profit or loss in accordance with IAS 39).
- Net exchange differences recognised in other comprehensive income and accumulated in a separate component of equity, and a reconciliation of the amount of such exchange differences at the beginning and end of the period.
- When the presentation currency is different from the functional currency, disclose that fact together with the functional currency and the reason for using a different presentation currency.
- A change in the functional currency of either the reporting entity or a significant foreign operation and the reason therefore.
When an entity presents its financial statements in a currency that is different from its functional currency, it may describe those financial statements as complying with IFRS only if they comply with all the requirements of each applicable Standard (including IAS 21) and each applicable interpretation.