The purpose of IAS 21The Effects of Changes in Foreign Exchange Rates is to outline the following issues:
- The definition of functional and presentation currencies
- Accounting for an entities individual transactions in a foreign currency
- Translation of the financial statements of a foreign subsidiary
FUNCTIONAL AND PRESENTATION CURRENCIES
The functional currency is the currency of the primary economic environment where the entity operates. In most cases, the functional currency is the currency of the country in which the entity is situated and in which it carries out most of its transactions. In essence, it is the currency an entity uses in its day-to-day transactions.
IAS 21 states that the following factors should be considered when determining the functional currency of an entity:
- The currency that mainly influences sales prices for goods and services (i.e. the currency in which prices are denominated and settled)
- 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, material and other costs of providing goods and services
- The currency in which funding from issuing debt and equity is generated
- The currency in which receipts from operating activities are usually retained
The first three points are seen as the primary factors in determining an entities functional currency.
Furthermore, if an entity is a foreign operation (i.e. a subsidiary, associate, joint venture or branch whose activities are based in a country or currency other than those of the reporting entity), the following factors must also be considered:
- Whether the activities of the foreign operation are carried out as an extension of the parent, rather than with a significant measure of autonomy/independence.
- Whether transactions with the parent are a high or low proportion of the foreign
- Whether cash flows from the foreign operation directly affect the cash flows of the parent and are readily available for remittance to it
- Whether cash flows from the activities of the foreign operation are sufficient to service existing debt obligations without funds being made available by the parent
Where the indicators are mixed, management must exercise its judgement as to the functional currency to adopt that best reflects the underlying transactions.
Putting the above into context, if an entity operates abroad as an independent operation (generating income and expenses and raising finance, all in its own local currency), then its functional currency would be its local currency. On the other hand, if the entity was merely an overseas extension of the parent and only sells goods imported from the parent and remits all profits back to the parent, then the functional currency should be the same as the parent. In this case, the foreign entity would record its transactions in the currency of the parent and not its local currency.
Once the functional currency has been determined, it is not subsequently changed unless there is a change in the underlying circumstances that were relevant when determining the original functional currency.
The presentation currency is the currency in which the financial statements are presented. IAS 21 states that, whereas an entity is constrained by the above factors in determining its functional currency, it has a completely free choice as to the currency in which it presents its financial statements.
If the presentation currency is different from the functional currency, then the financial statements must be translated into the presentation currency. Therefore, if a parent entity has subsidiaries whose functional currencies are different from that of the parent, then these must be translated into the presentation currency so that the consolidation process can take place.
ACCOUNTING FOR INDIVIDUAL TRANSACTIONS
When an entity enters into a contract where the consideration is denominated in a foreign currency, it will be necessary to translate that foreign currency into the entity’s functional currency for inclusion in its accounts. Examples of such foreign transactions include:
- Importing of raw materials
- Importing non-current assets
- Exporting finished goods
- Raising an overseas loan
- Investment in foreign shares / debt instruments
When translating the foreign currency transaction, the exchange rate used should be either:
- The spot exchange rate on the date the transaction occurred (the spot rate is the exchange rate for immediate delivery); or
- For practical reasons, an average rate over a period of time, providing the exchange rate has not fluctuated significantly
When cash settlement occurs, the settled amount should be translated using the spot rate on the settlement date. If the exchange rate has altered between the transaction date and the settlement date, there will be an exchange difference.
These exchange differences must be recognised as part of the profit or loss for the period in which they arise.
The treatment of any foreign items remaining in the statement of financial position will depend on whether they are classified as monetary of non-monetary items.
Monetary Items are defined as money /cash and assets and liabilities to be received or paid in fixed or determinable amounts. Examples include cash, receivables, payables, loans, deferred tax, pensions and provisions.
The main characteristic of non-monetary items is the absence of a right to receive a fixed or determinable amount of money. They represent other items in the statement of financial position that are not monetary items and include things like property plant and equipment, inventory, investments, prepayments, goodwill, intangibles and inventory.
The rule for the treatment of these foreign items at the reporting date is as follows:
Monetary items: Re-translate using the closing rate of exchange (i.e. the spot exchange rate at the reporting date)
Non-monetary items: Do not re-translate
Non-monetary items measured at cost less depreciation are translated
and recorded at the exchange rate at the date of their acquisition
Items measured at fair value less depreciation should be translated and
recorded at the exchange rate at the date of revaluation
Exchange differences arising on the re-translation of monetary items at the reporting date must be recognised as part of the profit or loss for the period in which they arise.
Similarly, exchange differences arising on the subsequent settlement of these monetary items after the reporting date should be recognised as part of the profit or loss for the period in which they arise.
TRANSLATING THE FINANCIAL STATEMENTS OF FOREIGN OPERATION
Where a subsidiary entity’s functional currency differs from the presentation currency of its parent, its financial statements must be translated into the parent’s presentation currency prior to consolidation.
There are a number of different methods that can be used to deal with the translation of a foreign subsidiary. The method below outlines one such approach.
The following exchange rates should be used in the translation:
Income Statement / Statement of Comprehensive Income:
Income: average rate for the year Expenses: average rate for the year
Note that the average rate for the year is used for expediency. Ideally, each item of income and expenditure should be translated at the rate in existence for each transaction. But if there has been no significant variance over the period, the average rate can be used.
Statement of Financial Position:
Assets & Liabilities: closing rate (i.e. the rate at the reporting date)
Share Capital: historic rate (i.e. the rate at the date of acquisition)
Pre-Acquisition reserves: historic rate
Post –Acquisition reserves: Balancing figure
Exchange differences arise because items are translated at different points in time at different rates of exchange, for example, the profit or loss for the year forms part of the entity’s overall retained earnings in the Statement of Financial Position. But, the profit or loss for the year is arrived at by using the average rate, whereas the reserves figure as a whole in the Statement of Financial Position does not use the average rate at all.
The exchange difference arising will form part of the total exchange difference disclosed as other comprehensive income and accumulated in other components of equity.
Income Statement / Statement of Comprehensive Income:
NCI is the share of the subsidiary’s profit as translated for consolidated purposes
Statement of Financial Position:
NCI is calculated by reference to either the net assets of the subsidiary or the fair value at acquisition plus the share of post acquisition profits.
In either case, the NCI is translated at the closing rate at the reporting date.
CASH FLOW STATEMENTS AND OVERSEAS TRANSACTIONS
An Individual Company
Exchange differences will normally be a part of operating profit, and so there is no problem if the foreign currency transaction is settled during the year.
If a transaction has not been settled, then there is no cash flow, and any exchange difference must be eliminated when preparing the cash flow statement. This is straightforward when the foreign currency transaction is in working capital, as the adjustment will automatically be made when calculating the cash flow from operating activities.
Consolidated Cash Flow Statements
Under both the net investment method and the Functional currency method, exchange differences will not reflect cash inflows or outflows for the group.
The cash flow statement should show the real cash flows for the year.