The Effects of Changesin Foreign Exchange

Rates: IAS 21

Wiecek and Young

IFRS PrimerChapter 35

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The Effects of Changes in Foreign Exchange Rates

Related standards IAS 21 Current GAAP comparisons Looking ahead End-of-chapter practice

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Related Standards

FAS 52 Foreign Currency Translation

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IAS 21 – Overview

Objective and scope Summary of the approach required by this

standard Reporting foreign currency transactions in the

functional currency Use of a presentation currency other than the

functional currency Disclosure

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IAS 21 – Objective and Scope Entity financial statements are sensitive to changes in foreign exchange rates

Three factors, which stem from the entity’s underlying business model and business environment

1. Foreign transactions (e.g., buying or selling in other countries)

2. Foreign operations (e.g., operating a business in other countries)

3. Presentation currency (e.g., presenting financial statements in another currency)

1. Transactions– Many entities enter into transactions denominated in other currencies as part of their

normal day-to-day business activities

– Any contract that is entered into, which is denominated in another currency and/or requires settlement in another currency, will be affected by changes in exchange rates

– Examples include foreign purchases and borrowing/lending in another currency

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IAS 21 – Objective and Scope2. Operations

– Entities may also own businesses that are located in different countries– Advantages may include tax incentives, access to raw materials, etc.

Foreign operation– 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

3. Presentation of financial statements– An entity may choose to present its financial statements in a foreign currency

– An entity may do this because it accesses capital markets in another country need to make the statements more comparable and understandable to local users

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IAS 21 – Objective and ScopeVarious currencies

Foreign currency is a currency other than the functional currency of the entity

Functional currency is the currency of the primary economic environment in which the entity operates

Presentation currency is the currency in which the financial statements are presented

Derivatives, hedges, and balances covered by IAS 39 are not covered by IAS 21

– Except when the entity translates these items from its functional currency into its presentation currency

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IAS 21 – Summary of the Approach Required by this Standard

The processStep 1: Determine functional currency for both the parent and any foreign

operations (this will be used for measurement in step 2)

Step 2: Translate items into the functional currency

Step 3: Identify and translate items into the presentation currency

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IAS 21 – Summary of the Approach Required by this Standard

Factors to consider in making the step 1 decision: • Sales

• Regulatory and competitive environment

• Labor and raw materials

• Financing currency

• Operating currency

Additional factors for foreign subsidiaries• Independence

• Relative volume/size of transactions with parent

• Cash management

• Self-sufficiency

If uncertain, management would give priority to the following factor• Sales markets

• Regulatory and competitive environment

• Labor and raw materials markets

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IAS 21 – Reporting Foreign Currency Transactions in the Functional Currency

Initial recognition– Foreign currency transactions are initially recognized in the functional currency

– Current exchange rate (known as the spot rate) is used in translating the foreign currency amount

– Average weekly or monthly rate can be used must be numerous transactions and the exchange rate does not fluctuate significantly

Reporting at the ends of subsequent reporting periods– In many cases, transactions result in balances that remain at the financial

statement date

– Balances are divided into two categories: monetary non-monetary

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IAS 21 – Reporting Foreign Currency Transactions in the Functional Currency

Monetary items – Units of currency held and assets and liabilities to be received or paid in a fixed or

determinable number of units of currency– E.g., receivables, payables, and cash balances– Defining attribute: fixed in terms of the amount of currency units that they represent

Non-monetary items – Everything else

Guidance for translating balances at the ends of subsequent periods• Monetary items

– At the year-end spot rate

• Non-monetary items that are measured in terms of historical cost in a foreign currency– At the historical exchange rate

• Non-monetary items that are measured at fair value in a foreign currency– At the rate in effect when the fair value was determined

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IAS 21 – Reporting Foreign Currency Transactions in the Functional Currency

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IAS 21 – Reporting Foreign Currency Transactions in the Functional Currency

Recognition of exchange differences Any gains/losses produced on translation are recognized in profit or loss in

the period they arise

Three exceptions• Hedges

• Non-monetary items, where IFRSs require all related gains/losses to be recorded, for instance, to OCI

– Related foreign exchange gains/losses should also be recorded to OCI

• Monetary item which is treated as part of the investment in the foreign operation,

is recorded to OCI– Such as a long-term receivable from a foreign operation

Change in functional currency Where an entity changes its functional currency, the change is applied prospectively

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IAS 21 – Use of a Presentation Currency Other than the Functional Currency

Translation to the presentation currency Step 3 results in an additional translation, where the entity chooses to

present its statements in a currency other than the functional currency

Guidance• Assets and liabilities are recorded at the closing exchange rate

• Income and expenses are recorded at the rate in effect when the transactions occurred

• Resulting translations gains/losses are recorded through OCI

Translation gains and losses– Not recognized in profit or loss initially because they have little or no effect on present

or future cash flows from operations– Will be recognized through profit or loss on disposal of the foreign operation

Hyperinflationary economy exists – All amounts are translated at the closing rates except for comparatives, which shall

remain at the prior year’s translation rates– When the entity’s functional currency is that of a hyperinflationary economy, additional

guidance is provided

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IAS 21 – Use of a Presentation Currency Other than the Functional Currency

Translation of a foreign operation Intercompany payables

– Expose either the parent or foreign operation to an exchange risk – Related gains/losses are recorded through profit or loss– If they are part of the net investment, they are recorded to OCI

Foreign operation– Acceptable to have a different year end than the reporting entity – Year end must be within three months – Any significant changes or transactions in the intervening period are adjusted for

Statements of the foreign operation – Translated at the rates in effect at the date they are produced– Adjustments would be made for significant changes in exchange rates– Goodwill and fair value increments arising from business combinations are

treated as assets of the foreign operation

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IAS 21 – Use of a Presentation Currency Other than the Functional Currency

Disposal or partial disposal of a foreign operation Upon disposal of the foreign operation

– Any foreign exchange gains/losses previously recorded through OCI will be recorded through profit or loss

– Portion of exchange gains/losses attributable to the non-controlling interest is derecognized but not through profit or loss

Disposals include– Loss of control– Loss of significant influence– Loss of joint control

Partial disposals – Include payment of dividends when the dividend payment is itself a return of

investment or includes a return of investment

IAS 21 – Disclosure The following should be disclosed as per IAS 21

• Exchange gains and losses recorded through profit and loss and

comprehensive income

• Fact that the presentation currency is different from the

functional currency, if this is the case

• Where there has been a change in functional currency

Additional disclosures are required in certain situations

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Current GAAP Comparisons

Pages 22, 44 & 70 of 164 ofhttp://www.kpmg.co.uk/pubs/IFRScomparedtoU.S.GAAPAnOverview(2008).pdf

Current GAAP Comparisons

IFRS requires that non-monetary items measured at fair value be translated at the date the fair value determined (rather than balance sheet date)

IFRS has more comprehensive guidance for hyperinflationary economies

Disclosure are different

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Looking Ahead

Since the IASB and FASB have largely converged the standards, this topic is not part of the short-term convergence project

There are no plans to study issues relating specifically to foreign currency translation, as covered by IAS 21

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End-of-Chapter Practice

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End-of-Chapter Practice35-3 Lactose Inc. entered into the following transactions this year. The functional currency is U.S. dollars, which is also the presentation currency.

Issued a long-term receivable to a foreign subsidiary. Lactose does not intend to collect this money within the foreseeable future. The receivable is denominated in the functional currency of the foreign subsidiary.•Sold inventory for 100 FCUs in a foreign country when the exchange rate was $1FCU = $1.1. As a result of this, the receivables are still due at year end when the rate is $1FCU = $1.5.•Established a foreign subsidiary with a functional currency of FCUs.•Established a foreign subsidiary with a functional currency of U.S. dollars.•Took out a loan in FCUs with a U.S. bank due in 10 years.

InstructionsDiscuss how each of these would be accounted for.

35-4 Grunge Inc. has a foreign subsidiary whose functional currency is U.S. dollars (the same as Grunge). Grunge is currently preparing its annual financial statements and is in the process of translating the foreign subsidiary statements for consolidation purposes. Grunge would like to know how to handle the following.

•Goodwill that arose when the subsidiary was first acquired.•Fair value increment (arising from the same acquisition) allocated to buildings. The buildings are accounted for under the revaluation method.•Inventory that is carried at the lower of cost and net realizable value (cost is 100 FCUs and net realizable value is 90 FCUs). The inventory was acquired when the exchange rate was 1 FCU = $.90.

The year-end exchange rate is 1 FCU = $1.1.

InstructionsDiscuss how each item should be accounted for in Grunge Inc.’s year-end statements.

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End-of-Chapter Practice

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