1 IAS 21 The effects of changes in foreign exchange rates
IAS 21 deals with:
- the definition of functional and presentation currencies
- accounting for individual transactions in a foreign currency
- translating the financial statements of a foreign operation.
Translating the financial statements of a foreign operation is covered in a later chapter.
Functional and presentation currencies
An entity maintains its day-to-day financial records in its functional currency.
Functional currency is the ‘currency of the primary economic environment where the entity operates’ (IAS 21, para 8).
IAS 21 (para 9) says that an entity should consider the following primary factors when determining its functional currency:
- ‘the currency that mainly influences sales prices for goods and services
- the currency of the country whose competitive forces and regulations mainly determine the sales price of goods and services
- the currency that mainly influences labour, materials and other costs of providing goods and services’.
If the primary factors are inconclusive then the following secondary factors should also be considered:
- the currency in which funds from financing activities are generated
- the currency in which receipts from operating activities are retained.
There are times when a foreign subsidiary, rather than applying the above rules, should simply use the same functional currency as its parent. In determining this, IAS 21 says that the following factors should be considered:
- whether the foreign operation operates as an extension of the parent, rather than having significant autonomy
- the level of transactions with the parent
- whether cash flows are readily available for remittance to its parent
- whether the foreign operation has sufficient cash flows to service its debts without needing funds from its parent.
The presentation currency is defined by IAS 21 as the currency in which the entity presents its financial statements. This can be different from the functional currency.
Test your understanding 1 – Chive
Chive is an entity located in a country whose currency is dollars ($).
Seventy per cent of Chive’s sales are denominated in dollars and 30% of them are denominated in sterling (£). Chive does not convert receipts from customers into other currencies. Chive buys most of its inventories, and pays for a large proportion of operating costs, in sterling.
Chive has two bank loans outstanding. Both of these loans are denominated in dollars.
Required:
What is the functional currency of Chive?
2 Accounting for individual transactions designated in a foreign currency
Where an entity enters into a transaction denominated in a currency other than its functional currency, that transaction must be translated into the functional currency before it is recorded.
The exchange rate used to initially record transactions should be either:
- the spot exchange rate on the date the transaction occurred, or
- an average rate over a period of time, providing the exchange rate has not fluctuated significantly.
Cash settlement
When cash settlement occurs, such as when cash is received from an overseas credit customer, the settled amount should be translated into the functional currency using the spot exchange rate on the settlement date. If this amount differs from that used when the transaction occurred, there will be an exchange difference.
Exchange differences on settlement
IAS 21 requires that exchange gains or losses on settlement of individual transactions are recognised in profit or loss in the period in which they arise.
IAS 21 is not definitive in stating where in profit or loss any such gains or losses are classified. It would seem reasonable to regard them as items of operating expense or income. However, other profit or loss headings may also be appropriate.
Illustration – Exchange differences on settlement
On 7 May 20X6 an entity with a functional currency of dollars ($) sold goods to a German entity for €48,000. On this date, the rate of exchange was $1 = € 3.2.
The sale is translated into the functional currency using the exchange rate in place on the transaction date.
| $ | |
| Dr Receivables (€48,000/3.2) | 15,000 |
| Cr Revenue | 15,000 |
On 20 July 20X6 the customer paid the outstanding balance. On this date, the rate of exchange was $1 = €3.17.
The settlement is translated into the functional currency using the exchange rate in place on the settlement date.
| $ | |
| Dr Cash (€48,000/3.17) | 15,142 |
| Cr Receivables | 15,000 |
| Cr Profit or loss (exchange gain) | 142 |
The $142 exchange gain forms part of the profit for the year.
Treatment of year-end balances
The treatment of any overseas items remaining in the statement of financial position at the year-end will depend on whether they are monetary or non-monetary. The rules in IAS 21 (para 8) stipulate the following:
Exchange differences on retranslation of monetary items
As with exchange differences arising on settlement, IAS 21 requires that exchange differences arising on retranslation of monetary assets and liabilities must be recognised in profit or loss.
IAS 21 does not specify the heading(s) under which such exchange gains or losses should be classified. It would seem reasonable to regard them as items of operating income or operating expense as appropriate.
Illustration – Monetary items
On 7 May 20X6 an entity with a functional currency of dollars ($) sold goods to a German entity for €48,000. On this date, the rate of exchange was $1 = € 3.2.
The sale is translated into the functional currency using the exchange rate in place on the transaction date.
| $ | |
| Dr Receivables (€48,000/3.2) | 15,000 |
| Cr Revenue | 15,000 |
By the reporting date of 31 July 20X6, the invoice had not been settled.
On this date, the rate of exchange was $1 = €3.4.
Receivables are a monetary item so must be retranslated into the entity’s functional currency at the year end using the closing exchange rate.
The receivable at year end should therefore be held at $14,118 (€48,000/3.4). The following entry is required:
| $ | |
| Dr Profit or loss (exchange loss) | 882 |
| Cr Receivables ($15,000 – $14,118) | 882 |
Illustration – Non-monetary items
Olympic, which has a functional and presentation currency of the dollar ($), accounts for land using the cost model in IAS 16. On 1 July 20X5, Olympic purchased a plot of land in another country for 1.2 million dinars.
| Relevant exchange rates: | Dinars to $1 |
| 1 July 20X5 | 4.0 |
| 30 June 20X6 | 3.0 |
The land is initially recognised at cost. This should be translated into the functional currency using the exchange rate on the purchase date. The land is therefore initially recorded at $300,000 (1.2m dinars/4.0).
Land is not a monetary item so is therefore not retranslated. In accordance with IAS 16, no depreciation is charged. This means that the land remains at $300,000.
Illustration – Non-monetary items at fair value
Pallot, which has a functional and presentation currency of the dollar ($), accounts for land using the revaluation model in IAS 16. On 1 July 20X5, Pallot purchased a plot of land in another country for 1.2 million dinars. At 30 June 20X6, the fair value of the plot of land was 1.5 million dinars.
| Relevant exchange rates: | Dinars to $1 |
| 1 July 20X5 | 4.0 |
| 30 June 20X6 | 3.0 |
The land is initially recognised at cost. This should be translated into the functional currency using the exchange rate on the purchase date. The land is therefore initially recorded at $300,000 (1.2m dinars/4.0).
Land is not a monetary item so its cost is not retranslated. However, in accordance with the revaluation model in IAS 16, a fair value has been determined. This valuation is in dinars and so must be translated into the functional currency using the exchange rate in place when the fair value was determined. This means that the land will must be revalued to $500,000 (1.5m dinars/3.0).
The increase in the carrying value of the land of $200,000 ($500,000 – $300,000) will be reported as a revaluation gain in other comprehensive income for the year and a revaluation reserve will be included within other components of equity on the statement of financial position at the reporting date.
Test your understanding 2 – Butler, Waiter and Attendant
- An entity, Butler, has a reporting date of 31 December and a functional currency of dollars ($). On 27 November 20X6 Butler plc buys goods from a Swedish supplier for SwK 324,000.
On 19 December 20X6 Butler plc pays the Swedish supplier in full. Exchange rates were as follows:
27 November 20X6 – SwK 11.15: $1
19 December 20X6 – SwK 10.93: $1
Required:
Describe how the above transaction should be accounted for in the financial statements of Butler for the year ended 31 December 20X6.
- An entity, Waiter, has a reporting date of 31 December and the dollar ($) as its functional currency. Waiter borrows in the foreign currency of the Kram (K). The loan of K120,000 was taken out on 1 January 20X7. A repayment of K40,000 was made on 1 March 20X7.
Exchange rates were as follows
1 January 20X7 – K1: $2
1 March 20X7 – K1: $3
31 December 20X7 – K1: $3.5
Required:
Describe how the above should be accounted for in the financial statements of Waiter for the year ended 31 December 20X7.
- An entity, Attendant, has a reporting date of 31 December and has the dollar ($) as its functional currency. Attendant purchased a plot of land overseas on 1 March 20X0. The entity paid for the land in the currency of the Rylands (R). The purchase cost of the land at 1 March 20X0 was R60,000. The value of the land at the reporting date was R80,000.
Exchange rates were as follows:
1 March 20X0 – R8 : $1
31 December 20X0 – R10 :$1
Required:
Describe how the above transaction should be accounted for in the financial statements of Attendant for the year ended 31 December 20X0 if the land is measured at:
- cost
- fair value.
Test your understanding 3 – Highlight
- Highlight is an entity whose functional currency is the dollar ($) and has an annual reporting date of 31 December.
On 1 July 20X3, Highlight purchased an item of plant and equipment on credit for Dn400,000. On 1 November 20X3, Highlight made a payment of Dn180,000 to the supplier. The balance of the invoice remains outstanding.
Highlight has a policy of applying historical cost accounting and depreciating plant and equipment at the rate of 20% per annum. The item of plant and equipment is not expected to have any residual value at the end of its useful life.
| Relevant exchange rates to $1 are as follows: | |
| Dn | |
| 1 July 20X3 | 10.0 |
| 1 November 20X3 | 7.2 |
| 1 December 20X3 | 9.0 |
| 31 December 20X3 | 8.0 |
Required:
Prepare relevant extracts from Highlight’s financial statements for the year ended 31 December 20X3 to illustrate the impact of the above transactions.
- During 20X3, Highlight entered into a number of transactions with Eraser, an overseas customer.
On 1 November 20X3, Highlight made credit sales to Eraser on 3 months credit for Dn360,000. On 1 December 20X3, Highlight made further credit sales to Eraser on 3 months credit for Dn540,000.
By 31 December 20X3, Highlight had received no payment from Eraser. As the receivables were still within their credit period, they were not regarded as being impaired.
| Relevant exchange rates to $1 are as follows: | |
| Dn | |
| 1 July 20X3 | 10.0 |
| 1 November 20X3 | 7.2 |
| 1 December 20X3 | 9.0 |
| 31 December 20X3 | 8.0 |
Required:
Prepare relevant extracts from Highlight’s financial statements for the year ended 31 December 20X3 to illustrate the impact of the above transactions.
Test your understanding 1 – Chive
Firstly, the primary indicators of functional currency should be applied. Most of Chive’s sales are denominated in dollars and so this would suggest that the dollar is its functional currency. However, since a lot of the costs of the business are denominated in sterling, it could be argued that its functional currency is sterling.
Since the primary indicators of functional currency are not clear cut, it is important to look at the secondary indicators. Receipts are retained in both dollars and sterling. However, funding is generated in the form of dollar loans, which further suggests that the dollar might be Chive’s functional currency.
All things considered, it would seem that the functional currency of Chive is dollars. This means that any business transactions that are denominated in sterling must be translated into dollars in order to record them.
Test your understanding 2 – Butler, Waiter and Attendant
- The transaction on 27 November 20X6 must be translated using the exchange rate on the transaction date.
The transaction is recorded at $29,058 (SwK324,000/11.15).
| Dr Purchases | $29,058 |
| Cr Payables | $29,058 |
The cash settlement on 19 December 20X6 must be translated using the exchange rate on the settlement date.
The cash settlement is recorded at $29,643 (SwK324,000/10.93).
| Dr Payables | $29,058 |
| Dr Profit or loss | $585 |
| Cr Cash | $29,643 |
An exchange loss of $585 has arisen and this is recorded in the statement of profit or loss.
- On 1 January 20X7, money was borrowed in Krams. This must be translated into the functional currency using the exchange rate on the transaction date.
| The transaction is recorded at $240,000 (K120,000 × 2). | |
| Dr Cash | $240,000 |
| Cr Loans | $240,000 |
The cash settlement on 1 March 20X7 must be translated into the functional currency using the exchange rate on the settlement date.
The cash settlement is recorded at $120,000 (K40,000 × 3).
| Dr Loans | $120,000 |
| Cr Cash | $120,000 |
Loans are a monetary liability. At the reporting date, the remaining loan of K80,000 (K120,000 – K40,000) must be translated at the year end exchange rate. This gives a closing liability of $280,000 (K80,000 × 3.5).
The exchange loss on retranslation is calculated as follows:
| K | Rate | $ | |
| 1 January 20X7 | 120,000 | 2.0 | 240,000 |
| 1 March 20X7 | (40,000) | 3.0 | (120,000) |
| Exchange loss (bal. fig) | 160,000 | ||
| –––––– | ––––––– | ||
| 31 December 20X7 | 80,000 | 3.5 | 280,000 |
| –––––– | ––––––– | ||
| The double entry to record this loss: | |||
| Dr Profit or loss | $160,000 | ||
| Cr Loans | $160,000 |
- The asset is initially recognised at cost. This should be translated into the functional currency using the exchange rate on the purchase date. The land is therefore initially recorded at $7,500 ($60,000/8).
Land is not a monetary item so is therefore not retranslated. If held under the cost model, it will remain at $7,500
If the land is held at fair value, then the valuation must be translated into dollars using the exchange rate in place when determined. Therefore, the land will be revalued to $8,000 (R80,000/10).
The carrying value of the land must be increased by $500 ($8,000 – $7,500).
If the land is held under IAS 40 Investment Property, then the gain will be recorded in profit or loss.
If the land is held under IAS 16 Property, Plant and Equipment, then the gain will be recorded in other comprehensive income.
Test your understanding 3 – Highlight
- Both the purchase of plant and equipment and the associated payable are recorded using the rate ruling at the date of the transaction (Dn10 = $1), giving a value of $40,000. The part-payment made on 1 November is recorded using the rate applicable on that date, with the remaining dinar liability being restated in dollars at the closing rate at the reporting date. The exchange difference, in this case a loss of $12,500 (see calculation below), is taken to profit or loss as an operating expense.
| Dn | Rate | $ | ||
| 1/7/X3 | Payable recorded | 400,000 | 10.0 | 40,000 |
| 1/11/X3 | Part-payment made | (180,000) | 7.2 | (25,000) |
| Exchange loss (bal. fig.) | 12,500 | |||
| –––––– | –––––– | |||
| 31/12/X3 | Payable outstanding | 220,000 | 8.0 | 27,500 |
| –––––– | –––––– |
Plant and equipment, as a non-monetary item, is accounted for at historic cost and is therefore not retranslated. The depreciation charge is $4,000 ($40,000 × 1/5 × 6/12).
Extracts of the financial statements for the year ended 31 December 20X3 are as follows:
| Statement of profit or loss: | $ | |
| Cost of sales (depreciation) | (4,000) | |
| Operating expenses (exchange loss) | (12,500) | |
| Statement of financial position: | 36,000 | |
| Property, plant and equipment ($40,000 – $4,000) | ||
| Current liabilities | 27,500 |
- Each of the sales invoices denominated in Dn must be translated into $ using the spot rate on the date of each transaction. Each transaction will result in recognition of revenue and a trade receivable at the following amounts:
1 November 20X3: Dn360,000/7.2 = $50,000
1 December 20X3: Dn540,000/9.0 = $60,000
Both amounts remain outstanding at the reporting date and must be restated into dollars using the closing rate of Dn8 = $1. The exchange difference, in this case a gain of $2,500 (see calculation below), is taken to profit or loss as an item of other operating income.
| Dn | Rate | $ | ||
| 1/11/X3 | Receivable recorded | 360,000 | 7.2 | 50,000 |
| 1/12/X3 | Receivable recorded | 540,000 | 9.0 | 60,000 |
| Exchange gain (bal. fig.) | 2,500 | |||
| –––––– | –––––– | |||
| 31/12/X3 | Receivable outstanding | 900,000 | 8.0 | 112,500 |
| –––––– | –––––– |
Extracts of the financial statements for the year ended 31 December 20X3 are as follows:
Statement of profit or loss:
Revenue ($50,000 + $60,000)
Other operating income (exchange gain)
Statement of financial position:
Receivables
$
110,000
2,500
112,500
