IAS 21 The Effects of Changes in Foreign Exchange Rates

 If a company trades overseas, it will buy or sell assets in foreign currencies. For example, and Indian company might buy
materials from Canada, and pay for them in Canadian dollars, and the sell its finished goods in Germany, receiving payments in
euros, or perhaps in some other currency.
 If the company owes money in a foreign currency at the end of the accounting year or holds assets which were bought in a
foreign currency then those liabilities or assets must be translated into the local currency in order to be shown in the books of
account.
 A company might have a subsidiary abroad (foreign entity that it owns) and the subsidiary will trade in its own local currency.
The subsidiary will keep books of account and prepare its annual accounts in its own currency. However, at the year end, the
holding (parent) company must “consolidate” the results of the overseas subsidiary into its group FS, so that somehow, the assets
and liabilities and the annual profits of the subsidiary must be translated from the foreign currency into $.
 If foreign currency exchange rates remained constant, there would be no accounting problem. As you will be aware, however,
foreign exchange rates are continually changing and it is not inconceivable.

There are two distinct types of foreign currency transaction, conversion and translation.
1. Conversion
 Conversion is the process of exchanging amounts of one foreign currency for another.
 Profit or losses on conversion would be included in profit or loss for the year in which conversion takes place (whether payment
or receipt).

2. Translation
 Foreign currency translation, as distinct from conversion, does not involve the act of exchanging one currency for another.
 Translation is required at the end of an accounting period when a local company still holds assets or liabilities in its SOFP which
were obtained or incurred in a foreign currency. The assets or liabilities might consist of any of the following:
1. An individual local company holding individual assets or liabilities originating in a foreign currency “deal”
2. An individual local company with a separate branch of the business operating abroad which keeps its own books of account
in the local currency
3. A local company which wishes to consolidate the results of a foreign subsidiary.

 There has been great uncertainty about the method which should be used to translate the following
 Value of assets and liabilities from a foreign currency into $ for the year end SOFP
 Profits of an independent foreign branch or subsidiary into $ for the annual SOPLOCI

 Functional currency is the currency or the primary economic environment in which the entity operates
 Foreign currency is a currency other than the functional currency of an entity.
 Presentation currency: the currency in which the FS are presented

 Exchange rate: the ratio of exchange for two currencies

 Exchange difference: the difference resulting from translating a given number of units of one currency into another currency at
different exchange rates

 Closing rate: the spot exchange rate at the end of the reporting period
 Spot exchange rate is the exchange rate for immediate delivery

 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

 Each entity – whether and individual company, a parent of a group, or an operation within a group (such a subsidiary, associate or
branch) – should determine its functional currency and measure its results and financial position in that currency.
 For most individual companies the functional currency will be the currency of the country in which they are located and in which
they carry out most of their transactions. Determining the functional currency is much more likely to be an issue where an entity
operates as part of a group.
 An entity can present its FS in any currency (or currencies) it chooses. IAS 21 deals with the situation in which FS are presented
in a currency other than the functional currency. Again, this is unlikely to be an issue for most individual companies. Their
presentation currency will normally be the same as their functional currency (the currency of the country in which they operate)
Foreign currency transaction
 IAS 21 states that a foreign currency transaction should be recorded, on initial recognition in the functional currency, by applying
the exchange rate between the reporting currency and the foreign currency at the date of the transaction to the foreign currency
amount. An average rate for a period may be used if exchange rates do not fluctuate significantly.

 Reporting at subsequent year-ends. The following rules apply at each subsequent year end.
1. Monetary items shall be translated using the closing rate
2. Non-monetary items which are carried at historical cost in a foreign currency shall be translated using the exchange rate at the
date of the transaction (historical rate)
3. Non-monetary items which are carried at fair value in a foreign currency shall be translated using the exchange rate at the
date when the fair value was measured

Recognition of exchange differences

 Exchange differences occur when there is a change in the exchange rate between the transaction date and the date of settlement
of monetary items arising from a foreign currency transaction.
 Exchange differences arising on the settlement of monetary items (receivable, payables, loans, cash in a foreign currency) or on
translating monetary items at rates different from those at which they were translated on initial recognition during the period or in
previous FS, should be recognised in profit or loss in the period in which they arise.

There are two situations to consider

1. The transaction is settled in the same period as that in which it occurred: all the exchange difference is recognised in that period
2. The transaction is settled in a subsequent accounting period: the exchange difference recognised in each intervening period up to
the period of settlement is determined by the change in exchange rates during that period.

 In other words, where a monetary items has not been settled at the end of a period, it should restated using the closing exchange
rate and any gains or losses taken to profit or loss.
 When a gain or loss on a non-monetary item is recognised in OCI any related exchange differences should also be recognised in
OCI. (for example where property is revalued)
Determining functional currency

Functional currency is the currency or the primary economic environment in which the entity operates. The primary economic
environment in which an entity operates is normally the one in which it primarily generates and expends cash.

 IAS 21 states that an entity should consider the following factors in determining its functional currency
1. The currency that mainly influences sales prices for goods and services
2. The currency of the country whose competitive forces and regulations mainly determine the sales prices of its goods and
services
3. The currency that mainly influences labour, material and other costs of providing goods or services (often the currency in which
prices are denominated and settled)

 Sometimes the functional currency of an entity is not immediately obvious. Management must then exercise judgement and may
also need to consider:
1. The currency in which funds from financing activities are generated (raising loans and issuing equity instruments)
2. The currency in which receipts from operating activities are usually retained

 Where a parent has a foreign operation a number of factors are considered:

1. Whether the activities of the foreign operation are carried out as an extension of the parent, rather than being carried out with a
significant degree of autonomy
2. Whether transactions with the parent are a high or a low proportion of the foreign operation’s activities
3. Whether cash-flows from the activities of the foreign operations directly affect the cash-flows of the parent and are readily
available for remittance to it
4. Whether cash-flows from the activities of the foreign operations are sufficient to service existing and normally expected debt
obligations without funds being made available by the parent

 When the above indicators are mixed and the functional currency is not obvious, management uses its judgement to determine the
functional currency that most faithfully represents the economic effects of the underlying transactions, events and conditions.

Change in functional currency

 The functional currency of an entity can be changed only if there is a change to the underlying transactions, events and conditions
that are relevant to the entity. For example, an entity’s functional currency may change if there is a change in the currency that
mainly influences the sales prices of goods and services
 Where there is a change in an entity’s functional currency, the entity should translate all items into the new functional currency
prospectively from the date of the change using the exchange rate at the date of the change.

 A holding or parent company with foreign operation must translate the financial statements of those operations into its own
reporting currency before they can be consolidated into the group FS. There are two methods and the method used depends upon
whether the foreign operation has the same functional currency as the parent. The translation method used has to reflect the
economic reality of the relationship between the reporting entity (the parent) and the foreign operation.

1. Same functional currency as the parent.

 In this situation, the foreign operation normally carries on its business as though it were an extension of the parent’s
operations. For example, it may sell goods imported from, and remit the proceeds directly to, the reporting entity.
 Any movement in the exchange rate between the reporting currency and the foreign operation’s currency will have an
immediate impact on the parent’s cash-flows from the foreign operations. In other words, changes in the exchange rate affect the
individual monetary items held by the foreign operations, not the parent’s net investment in that operation.

2. Different functional currency from the parent

 In this situation, although the parent may be able to exercise control, the foreign operation normally operates in a semi-
autonomous way. It accumulates cash and other monetary items, generates income and incurs expenses, and may also arrange
borrowings, all in its own local currency
 A change in the exchange rate will produce little or no direct effect on the present and future cash flows from operation of either
the foreign operation or the parent. Rather, the change in exchange rate affect the parent’s net investment in the foreign
operation, not the individual monetary and non-monetary items held by the foreign operations