International Accounting Standard 21 (IAS 21) defines exchange difference as “the difference resulting from translating a given number of units of one currency into another currency at different exchange rates”.
An entity may carry out transactions in foreign currency. The foreign currency is defined as a currency other than the functional currency of the entity. The functional currency is the currency of the primary economic environment in which the entity operates. If an entity deals in foreign currency transactions, it will have to translate it foreign currency transactions into the functional currency. An entity will also have to translate its financial statements if the presentation currency is different from the functional currency. Presentation currency is the currency in which the financial statements are presented.
The foreign exchange market is usually a volatile market. The exchange rates of different currencies keep on varying. Due to the changes in exchange rates, the exchange differences arise when the foreign currency transactions are converted to functional currency or when the functional currency is translated into presentation currency.
The exchange differences are recognized in the financial statements. The exchange differences which arise on monetary items are reported in the income statement in the period. 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. Examples of monetary items include cash, trade receivable, trade payables, and pensions and other employee benefits to be paid in cash.
There is one exception to the above rule. The exception is that the exchange differences that arise on monetary items that form part of the reporting entity’s net investment in a foreign operation are recognized in the group financial statements within a separate component of equity. These exchange differences are recognized in the profit or loss on disposal of the net investment.
The above accounting treatment was for the group financial statements. For the individual financial statements, the exchange differences that arise on monetary items that form part of the reporting entity’s net investment in foreign operation is recognized in the profit and loss for the period.
If any gain or loss nonmonetary item is recognized in equity (for example revaluation surplus on property, plant and equipment), any foreign exchange gain or loss is also recognized in the equity.