IAS 21 - The Effects of changes in Foreign exchange Rates (detailed review)

Objective

This standard prescribes the guidelines to account for the transactions designated in foreign currency and rules for the translation of financial statements of a foreign operation. It also deals with the requirements for the exchange rates to be used for translation of transactions designated in foreign currency and financial statements of a foreign operation including how to account for the effects of changes in exchange rates.

Scope

The requirements of this standard are applicable for:

a) The accounting treatment of transactions designated in foreign currency

b) The translation of financial statements of a foreign operation

c) The translation of financial statements of an entity into its presentation currency

However, the requirements of this standard are not applicable for the translation of cash flows from the foreign operation.

Definitions

Functional Currency

The currency of primary economic environment, where the entity operates and expands its business, is termed as functional currency.

Foreign Currency

The currency other than the functional currency of the enterprise is termed as foreign currency.

Presentation Currency

The currency in which entity will present its financial statements.

Closing Rate

The spot exchange rate which is prevalent at the end of the accounting period is termed as closing rate.

Exchange Difference

The difference arising on translation of a certain number of units of one currency into another currency at different exchange rates is termed as exchange rates.

Exchange Rate

It is the ratio of exchange between two currencies which is used to translate a certain number of units of one currency into another currency.

Foreign Operation

It is the entity whose business activities are carried out in a country or currency other than that of the reporting entity. It may be a subsidiary, associate, joint arrangement or branch of the reporting entity.

Monetary Item

It is any asset or liability for which currency units receivable or payable are determinable in fixed number of currency units such as trade receivable, bank deposit, loan payable and trade payable.

Net Investment in a Foreign Operation

It is the share of reporting entity in the net assets of a foreign operation.

Determination of Functional Currency

It is defined as the currency of primary economic environment where the entity operates and expands its business. The entity maintains its day to day records in terms of functional currency. The entity will use the following guidelines to determine the functional currency:

Primary Criteria

It includes the following aspects for the determination of functional currency of the entity:

• The currency which primarily affects the selling price of the goods or services supplied by the entity
• The currency in which selling price of the goods or services supplied by the entity is denominated
• The currency in terms of which entity earns its revenue and incurs costs
• The currency which primarily affects the material, labor and overhead costs related to the goods or services supplied by the entity
• The currency of the country whose regulatory authorities and competitive forces can affect the selling price of the goods or services supplied by the entity

Secondary Criteria

The entity should also consider the following aspects along with the primary criteria for the determination of functional currency of the entity:

• The currency in terms of which entity retains its proceeds from operating activities i.e. retained earnings
• The currency in terms of which entity raises its capital and long term funds

Other Factors:

The entity should also consider the following additional factors to determine the functional currency of the foreign operation (subsidiary, associate, joint arrangement or branch) in order to identify that either the functional currency of the foreign operation is same as of its parent or it is the currency of the environment where that foreign operation operates. These factors include:

a) Whether the activities of the foreign operation are expansion of the reporting entity business or the foreign operation is an independent autonomous operation

b) Whether the proportion of transactions of foreign operations with the reporting entity is significant or lower

c) Whether the cash flows of foreign operation are directly remitted to the reporting entity and the cash flows of foreign operation affects the cash flows of the reporting entity

d) Whether the foreign operation has sufficient funds to pay off its existing obligation or these are funded by the reporting entity

• If it is not clear about the functional currency of the entity even after applying the factors mentioned above, the entity will use its own judgment for the determination of its functional currency on the basis of its environment, events, transactions and prevalent conditions relating to the business.
• Once the functional currency is determined, the entity should not change its functional currency unless there is change in environment, events, transactions and prevalent conditions relating to the business.

Application Example

The functional currency of the AB Ltd is dollar as it operates in a dollar based economic environment. In the current financial year AB Ltd has acquired an investment in a foreign subsidiary Robby. This operates in an overseas country whose functional currency is dinars. The details of its operations are as follows:

Robby purchases material for its products at a price which is usually denominated in dollars. However, its products are sold in its local jurisdiction with the selling prices denominated in dinars, and the selling price of its products is primarily determined by local competition and regulatory authorities. Robby incurs and pays its general operating and selling expenses in its local currency dinars.

Robby has borrowed a loan of $2 million from AB Ltd to finance its operations and other than this loan, it is not dependent upon group companies for its finances. The management of Robby is independent in carrying out the operations of its business.

Required:

Apply the principles given in IAS 21 to determine the functional currency of Robby.

Solution:

Using the primary criteria, secondary criteria and other factors as given in IAS 21 to determine the functional currency of the entity, it appears that the functional currency of the Robby is dinars as:

• It operates in a dinar based economic environment
• It earns its revenue and incurs major costs in its local currency dinars
• Its selling price for the goods is denominated in dinars
• The local regulatory authorities and local competition affects the selling price of its products
• Its major capital funds are in its local currency dinars
• It is independent operations in overseas and is not dependent upon group for finances.

Accounting for Transactions designated in Foreign Currency

If an entity enters into transactions which are designated in foreign currency such as

• Imports from an overseas country which are in foreign currency
• Exports to an overseas country which are in foreign currency
• Loan borrowed from an overseas country in foreign currency
• Investment purchased in an overseas country in foreign currency
• Asset purchased from an overseas country in foreign currency

IAS 21 requires that the entity should maintain its day to day records in functional currency therefore, the entity will account for the transactions which are designated in foreign currency as follows:

Initial Recognition

The transaction will be initially recorded in the functional currency of the entity using spot exchange rate on the date of transaction

Subsequent Recognition

At reporting date, the entity will account for the transactions which are designated in foreign currency as follows:

1. Monetary Items:

These are the assets or liabilities for which currency units receivable or payable are determinable in fixed number of currency units, such as trade receivable, loan receivable, bank deposit, loan payable and trade payable.

• The entity will re-translate the monetary items in foreign currency at reporting date, using spot exchange rate at reporting date i.e. closing rate
• The exchange gain or loss on re-translation of monetary assets at reporting date will be charged to statement of profit or loss

2. Non-monetary Items:

These are the assets or liabilities for which currency units receivable or payable are not determinable in fixed number of currency units, such as inventory, property plant and equipment, investment property and intangible assets.

• If the non-monetary items are under cost model at reporting date, it will be re-translated using the spot rate at the date of transaction and there will be no exchange gain or loss in respect of these non-monetary items

• If the non-monetary items are under other model i.e. (property plant and equipment under revaluation model as per IAS 16, Investments measured at fair value as per IFRS 9 or Investment property under fair value model as per IAS 40) at reporting date, it will be re-translated using the spot rate at the date of re-measurement.

The resulting exchange gain or loss will be reported to statement of other comprehensive income (OCI), if the gains or losses of the related non-monetary item are reported to statement of other comprehensive income (OCI). And the exchange gain or loss will be reported to statement of profit or loss, if the gains or losses of the related non-monetary item are reported to statement of profit or loss.

Settlement Date

• At settlement date, (when receivable and payable are settled) the entity will re-translate the receivable or payable in foreign currency, using spot rate at the date of settlement and the resulting exchange gain or loss will be charged to statement of profit or loss

Net Investment in Foreign Operation

When a reporting entity has an amount receivable in long term from its foreign subsidiary for which redemption is not yet planned and it is not expected in the foreseeable future, such amount will be treated as part of the net investment in foreign operation by the reporting entity.

• This monetary item (Long term receivable) which forms the part of net investment in foreign operation by the reporting entity will be re-translated at reporting date using closing rate and the resulting exchange gain or loss will be recognized in the statement of profit or loss of the reporting entity or its subsidiary, whichever is relevant.
• However, on consolidation this exchange gain or loss relating to the monetary item (Long term receivable) which forms the part of net investment in foreign operation by the reporting entity will be reclassified to statement of other comprehensive income (OCI) and upon disposal this will be transferred to retained earnings.

Translation  to the Presentation Currency

If the presentation currency of the entity is different from its functional currency, the entity will apply the following rules to translate its results into its presentation currency as the financial statements are prepared in the presentation currency:

1) Foreign Operation

If the presentation currency of the foreign operation (subsidiary, associate or joint venture) is different from presentation currency of the group, the results of the foreign operation will be translated into the presentation currency of the group for the purpose of preparing consolidated financial statements. The entity will apply following rules to translate the results of the foreign operation (subsidiary, associate or joint venture) in the presentation currency of the group:

Statement of Financial Position	Exchange Rate
Assets & Liabilities (Monetary / Non-monetary)	Spot Rate at Reporting Date (Closing Rate)
Share Capital	Date of Acquisition Rate
Pre-Acquisition Reserves	Date of Acquisition Rate
Post- Acquisition Reserve	Balancing Figure

 

Statement of Profit or Loss	Exchange Rate
Income and Expenses	Average Rate during the year
Other Comprehensive Income	Average Rate during the year

Notes:

• After the translation of the results of foreign operation, the entity will apply the normal consolidation procedures as specified in IFRS 10 if foreign operation is a subsidiary and equity method as per IAS 28 if foreign operation is associate or joint venture

• This standard requires that for all income and expenses, the entity should use the spot rate on the date of transaction, but as it is impracticable to use spot rate on the date of transaction for each income and expense, therefore, the standard allows the use of average rate during the accounting period. However there should not be any material difference between the average rate and the spot rate on the date of transaction.

• The entity will use the spot rate on the date of transaction for the specific events such as impairment loss, dividend and provision

• The exchange differences will arise on the translation of foreign operation due to:

a) The translation of the assets and liabilities of foreign operation at current year closing rate which will be different from the closing rate at previous reporting date and

b) The translation of profit or loss of the foreign operation at closing rate which will be different from the average rate

• The goodwill arising on acquisition of foreign operation will be treated as a foreign currency asset and it will also be translated at reporting date using closing rate at current reporting date

• These exchange gain or losses on translation of foreign operation’s assets and liabilities and relating to goodwill will be reported to the statement of other comprehensive income and will be classified in a separate column in the statement of changes in equity till the disposal of related foreign operation

• Any unrealized profit upon intra-group transaction with foreign operation will be eliminated as normal but after translating the transaction, using spot rate on the date of transaction

• Any intra-group receivable and payable balance with the foreign operation will be cancelled out as normal but after re-translating at reporting date using closing rate at current reporting date

 

2) Other Entity

If the presentation currency of the entity is different from its functional currency, the entity will apply the following rules to translate its results into its presentation currency, as the financial statements are prepared in the presentation currency:

Items	Exchange Rate
Assets & Liabilities (Monetary / Non-monetary)	Spot Rate at Reporting Date (Closing Rate)
Income and Expenses	Average Rate during the year
Other Comprehensive Income	Average Rate during the year

Notes:

• This standard requires that for all income and expenses, the entity should use the spot rate on the date of transaction but as it is impracticable to use spot rate on the date of transaction for each income and expense, therefore, the standard allows the use of average rate during the accounting period. However there should not be any material difference between the average rate and the spot rate on the date of transaction

• The entity will use the spot rate on the date of transaction for the specific events such as impairment loss, dividend and provision

• These exchange gain or losses on translation of assets and liabilities will be reported to the statement of other comprehensive income

Disposal of Foreign Operation

Upon disposal of foreign operation, the entity will apply the following requirements:

• For disposal of foreign operations involving loss of control, the accumulative exchange gain and losses in the separate column of statement of changes in equity will be transferred to statement of profit or loss.

• For disposal of foreign operations which does not involve the loss of control, the exchange gain or losses recognized in statement of profit or loss will be allocated between the reporting entity and non-controlling interest in that foreign operation.

Disclosures

The standard requires the entity to disclose the following:

• The details about the functional currency and the basis used for the determination of functional currency
• Any amount Exchange gain or loss recognized in the statement of profit or loss in the current year
• Any amount Exchange gain or loss recognized in the statement of other comprehensive income in the current year
• If the functional currency and presentation currency of the entity is different, it should be disclosed with the reasons the difference
• The reasons for the change in the functional currency of the entity along with related events and conditions if there is change in the functional currency of the entity in the current year

 

Worked Example

AB Ltd is a dollar based entity and it has the following transaction in foreign currency during the current year:

AB Ltd sold goods for £10,000 on 1 January 2010 and receipts will be in Pound sterlings. The receivable were collected on 30 April 2010

The spot exchange rates were as follows:

Date	Exchange Rates ($1 to £)
1 January 2010	0.60
1 February 2010	0.65
31 March 2010	0.75
30 April 2010	0.80

Requirement:

How the above transaction in foreign currency will be accounted for in the financial statements of AB Ltd for the year ended 31 March 2010.

Solution:

1. As this is transaction is in foreign currency, it will be recorded in the functional   currency of AB Ltd i.e. dollars after translating using spot rate on the date of transaction.

Date of transaction 1 January 2010       

£10,000 / £0.60 = $16,667

Receivables a/c $16,667
                To Sale a/c $16,667

2. The receivables are still outstanding at reporting date i.e. 31 March 2010 and as this is a monetary asset in foreign currency at reporting date therefore, it will be re-translated at reporting date using closing rate and the resulting exchange gain or loss will be charge to statement of profit or loss

Reporting Date 31 March 2010

£10,000 / £0.75 = $13,333

The value of receivable has decreased at reporting date because of change in exchange rate. Therefore, there will be exchange loss of $3,334 ($16,667 - $13,333)

Profit or Loss a/c $3,334
To Receivable a/c $3,334

3. The receivable are collected on 30 April after the year end, this will be re-translated using spot rate at settlement date and the resulting exchange gain or loss will be charge to statement of profit or loss

£10,000 / £0.80 = $12,500

The value of receivable has further decreased at settlement date because of change in exchange rate. Therefore, there will be exchange loss of $833 ($13,333 - $12,500)

Cash a/c $12,500
Profit or Loss a/c $833
To Receivable a/c $13,333