The purpose of IAS 21 is to set out how to account for transactions in foreign currencies and foreign operations. The Standard also shows how to translate financial statements into a presentation currency. The presentation currency is the currency in which the financial statements are presented. The key issues are the exchange rate(s) that should be used and where the effects of changes in exchange rates are reported in the financial statements. This post emphasize specifically for the discussion through the following sections: Functional Currency, Recording Foreign Currency Transactions Using The Functional Currency, Recognition Of Currency Exchange Differences, Translation To The Presentation Currency From The Functional Currency, It is adapted from IAS 21, described with case examples for easier understanding.
The functional currency should be determined by looking at several factors. This currency should be the one in which the entity normally generates and spends cash and in which transactions are normally denominated. All transactions in currencies other than the functional currency are treated as transactions in foreign currencies. Five factors can be taken into account in making this decision: the currency…
- That mainly influences the price at which goods and services are sold
- Of the country whose competitive forces and regulations mainly influence the entity’s pricing structure
- That influences the costs of the entity
- In which funds are generated
- In which receipts from operating activities are retained
The first three items are generally considered to be the most influential in deciding the functional currency.
An entity will have to determine the functional currency of a foreign operation, such as a foreign subsidiary, and whether it is the same currency as that of the reporting entity. Such factors as whether the foreign entity is an extension of the reporting entity business, what proportion of its transactions are with the reporting entity, and the nature of the cash flows will help determine the functional currency of the foreign operation.
The entity’s functional currency reflects the transactions, events, and conditions under which the entity conducts its business. Once decided on, the functional currency does not change unless there is a change in the underlying nature of the transactions and relevant conditions and events.
If the functional currency is the currency of a hyperinflationary economy, the financial statements should be restated using IAS 29, Financial Reporting in Hyperinflationary Economies.
Where there is a change in the functional currency, it should be applied from the date of change. A change must be linked to a change in the nature of the underlying transactions. For example, a change in the major market may lead to a change in the currency that influences sales prices. The change is accounted for prospectively not retrospectively.
Recording Foreign Currency Transactions Using The Functional Currency
Foreign currency transactions should be recorded initially at the spot rate of exchange at the date of the transaction. An approximate rate can be used. For example, in general, an average rate for a particular period can be used, but if exchange rates are fluctuating wildly, an average rate cannot be used.
Subsequently, at each balance sheet date, foreign currency monetary amounts should be reported using the closing rate. Non-monetary items measured at historical cost should be reported using the exchange rate at the date of the transaction. Nonmonetary items carried at fair value should be reported at the rate that existed when the fair values were determined.
It is possible that the carrying value for an item will have been determined by a comparison of two amounts that have been measured at different dates. For example, the cost of inventory can have been determined at one date and the net realizable value or recoverable amount at another date. The effect may be to change the amount of any impairment loss recognized in the functional currency.
Case Study: An entity buys inventory from a foreign supplier for €4 million. The functional currency of the entity is the dollar. The date of the order was March 31, 20X6, the date of shipping was April 7, 20X6, the date of the invoice was April 8, 20X6, the date the goods were received was April 15, 20X6, and the date the invoice was paid was May 31, 20X6.
What is the date of the transaction for the purpose of recording the purchase of inventory?
Although IAS 2, Inventories, does not refer to the date of the initial recognition of inventory, IAS 39 says that a liability should be recognized when the entity becomes party to the contractual provisions of a contract. The date that the risks and rewards of ownership pass will essentially be the date of the transaction for these purposes.
It is unlikely that the ownership will pass on the date of the order, but it could pass on shipping, depending on the nature of the agreement. Similarly, it could pass on receipt of the goods, but it is unlikely to pass on receipt of the invoice or when payment is made. Thus the date of the transaction in this case is likely to be the date of shipping or date of receipt, depending on when the risks and rewards of ownership pass and who would suffer loss if the inventory was damaged or lost in transit.
Recognition Of Currency Exchange Differences
Exchange differences arising on monetary items are reported in profit or loss in the period, with one exception. The exception is that exchange differences arising 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. They are recognized in profit or loss on disposal of the net investment.
The exchange difference arising on monetary items that form part of the reporting entity’s net investment in a foreign operation is recognized in profit or loss in the entity financial statements. If a gain or loss on a non-monetary item is recognized in equity (e.g., property, plant, and equipment revalued under IAS 16), any foreign exchange gain or loss element is also recognized in equity.
Case Example: An entity purchases equipment from a foreign supplier for €6 million on March 31, 20X6, when the exchange rate was €2 = $1. The entity also sells goods to a foreign customer for €3.5 million on April 30, 20X6, when the exchange rate was €1.75 = $1. At the entity’s year-end of May 31, 20X6, the amounts have not been paid. The closing exchange rate was €1.5 = $1. The entity’s functional currency is the dollar.
How to calculate the exchange differences that would be recorded in profit or loss for the period ending May 31, 20X6?
The entity records the asset at a cost of $3 million at March 31, 20X6, and a liability of the same amount. At year-end, the amount has not been paid. Thus using the closing rate of exchange, the amount payable would be retranslated at $4 million, which would give an exchange loss of $1 million to be reported in profit or loss. The cost of the asset remains at $3 million before depreciation. Similarly, the entity will record a sale of $2 million and an amount receivable of the same amount. At year-end, the receivable would be stated at $2.33 million, which would give an exchange gain of $0.33 million, which would be reported in profit or loss.
IAS 21 does not specify where exchange gains and losses should be shown in the income statement.
Translation To The Presentation Currency From The Functional Currency
An entity can present its financial statements in any currency. If the presentation currency differs from the functional currency, the financial statements are retranslated into the presentation currency. If the financial statements of the entity are not in the functional currency of a hyperinflationary economy, then they are translated into the presentation currency in this way:
- Assets and liabilities [including any goodwill arising on the acquisition and any fair value adjustment] are translated at the closing spot rate at the date of that balance sheet.
- The income statement is to be translated at the spot rate at the date of the transactions [Average rates are allowed if there is no great fluctuation in the exchange rates]
- All exchange differences are recognized in a separate component of equity.
- Any exchange difference that relates to the minority interest is recognized in the balance sheet amount.
Special rules apply for translating into a different presentation currency the results and financial position of an entity whose functional currency is the currency of a hyperinflationary economy. All amounts are translated at the closing spot rate. The one exception is that the comparative amounts will be shown as presented in the previous period.
Case Example: An entity commenced business on January 1, 20X6, with an opening share capital of $2 million. The income statement and closing balance sheet follow:
Income Statement for the year ended December 31, 20X6
Cost of sales (10)
Gross profit 22
Distribution costs (8)
Administrative expenses (2)
Profit before tax 12
Tax expense (4)
Profit for period 8
Balance Sheet at December 31, 20X6
Share capital 2
Retained earnings 8
Trade payables 4
Total equity and liabilities 14
Land (non-depreciable) acq. Dec 31, 20X6 8
Trade receivables 2
Total assets 14
The functional currency is the dollar, but the entity wishes to present its financial statements using the euro as its presentational currency. The entity translates the opening share capital at the closing rate. The exchange rates in the period were:
January 1, 20X6 €1
December 31, 20X6 €2
Average rate €1.5
How to translate the financial statements from the functional currency to the presentational currency?
Income Statement for the year ended December 31, 20X6, at average rate:
(€1.5 = $1)
Cost of sales (15)
Gross profit 33
Distribution costs (12)
Administrative expenses (3)
Profit before tax 18
Tax expense (6)
Profit for period 12
Balance Sheet at December 31, 20X6
(€2 = $1)
Share capital (closing rate) 4
Retained earnings (above) 12
Exchange difference (see below) 4
Trade payables 8
Total equity and liabilities 28
Land (non-depreciable) acquired Dec31, 20X6 16
Trade receivables 4
Total assets 28
The exchange difference is calculated in this way:
The retained earnings if translated into euros would be €16 million. As the income statement has been translated using the average rate, the profit per that statement is €12 million, creating an exchange difference of €4 million. The total exchange difference of €4 million, is shown as a component of equity.
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