1. IAS 21: The Effects of Changes in
Foreign Exchange Rates
Roshankumar S Pimpalkar
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2. Scope:
This standard deals with:
Accounting for transactions and balances in foreign currencies;
Translating the results and financial position of foreign operations, included in
financial statements of the entity by consolidation, proportionate consolidation
or the equity method;
Translating entity’s results and financial position into a presentation currency.
This standard does not deal with:
Derivative transactions in foreign currencies and balances that are within the
scope of IAS 39: Financial Instruments: Recognition and Measurement.
Hedge accounting including the hedging of a net investment in foreign
operation.
The presentation of cash flows arising from transactions in foreign currency,
or with the translation of cash flows of a foreign operation.
Foreign Currency
A foreign currency is the currency other than the functional currency of the entity.
Functional Currency
The functional currency of an entity is the currency of the primary economic
environment in which that entity operates.
Primary economic environment in which an entity operates is normally the one in
which it primarily generates and expends cash.
Factors to determine functional currency:
1. Primary Evidence:
a. This factor is related to entity’s sales. An entity considers the currency
i. In which the sales prices of the goods and services are
denominated and settled. If the currency that mainly influences
sales prices is different, then this is considered. (e.g. US dollar
is considered for crude oil sales, even if sales are denominated
in a different currency)
ii. Of the country whose competitive forces and regulations mainly
determine the sales price of its goods and services. In general
this is viewed as which is the main driver for price changes. (e.g.
a local supermarkets price changes are driven by local
competition. This is not true for international airlines.)
b. This factor is related to operating expense
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3. An entity considers the currency in which labour, material and
other costs of providing goods or services are denominated and
settled. (or the currency that mainly influences such costs, if
different)
In general labour cost would be linked to the currency of the
country in which it operates, while material and other costs
would be driven by the currency of the country in which the
suppliers operate.
2. Secondary Evidence:
a. Financing Activities
An entity considers the currency in which the funds from financing
activities are generated.
b. Retention of operating income
An entity considers the currency in which the receipts from operating
activities are usually retained. This is the currency in which the entity
maintains the excess working capital cash balance (i.e. in general it
would be the local currency or a hard currency such as US dollar or
Euro)
Foreign Operation
A foreign operation is an entity:
Is a subsidiary, associate, joint venture or branch of a reporting entity, and
Has activities that are based or conducted in a country or currency other than
those of reporting entity.
The functional currency is determined separately for individual entities. in case of
foreign operation to find out functional currency four factors in addition to primary
and secondary factors shall be considered. These factors are
Whether its activities are carried out as an extension of the reporting entity or
with significant autonomy. If the activities are carried out as an extension then
this provides evidence that its functional currency should be same as that of
reporting entity.
Whether its transactions with the reporting entity are a high or low proportion
of its activities. If it is high proportion of its activities then this provides
evidence that its functional currency may be the same as that of reporting
entity.
Whether the cash flows of the foreign operation directly affect the cash
flows of the reporting entity and are available for remittance to it. If it is so then
this provides evidence that its functional currency may be the same as that of
reporting entity.
Whether the cash flows of the foreign operation are sufficient to service
debt obligation without the assistance from the reporting entity. If cash flows
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4. are not sufficient then this provides evidence that its functional currency may
be the same as that of reporting entity.
None of these criteria should be looked at in isolation but as a whole.
Presentation Currency
The currency in which the financial statements are presented is defined as
presentation currency. Unlike the functional currency the presentation currency can
be any currency of choice. If the presentation currency differs from functional
currency, the results and the financial position have to be translated into presentation
currency. Presentation currency does not change the way in which the underlying
items are measured but selection of wrong functional currency could affect the
measurement of items.
A foreign currency transaction is the one that is denominated or requires settlement
in a foreign currency. An entity must convert the foreign currency item into its
functional currency for recording in its books of accounts. Once recorded exchange
differences will arise.
Monetary items
Monetary items are units of currency held and assets and liabilities to be received or
paid in fixed or determinable amounts of units of currency.
Deferred tax, provisions to be settled in cash (e.g. accrued wages), debt security is
monetary item. Deferred income is not a monetary item.
Initial Recognition
The foreign currency transactions are recorded in functional currency by applying to
the foreign currency amount the spot exchange rate between the functional currency
and the foreign currency at the date of the transaction.
For practical reasons, a rate that approximates the actual rate at the transaction date
is often used on initial recognition. This will be average rate for the period and will be
used for all foreign currency transactions in that period. However, if exchange
fluctuates significantly then use of average rates is inappropriate.
Reporting at the end of subsequent reporting period
At the end of each reporting period the foreign currency monetary items are
translated using closing rate.
At the end of each reporting period, non-monetary items that are measured in terms
of historical cost in a foreign currency are translated using exchange rate at the
date of the transaction.
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5. At the end of each reporting period, non-monetary items that are measured at fair
value in a foreign currency are translated using the exchange rates at the date when
the value was determined.
When several exchange rates are available the rate to be used is that:
At which the future cash flows represented by the transaction or balance
could have been settled, if
Those cash flows had occurred at measurement date.
If the exchangeability between two currencies is temporarily blocked, the first
subsequent rate at which exchanges could be made is used.
Exchange differences on Monetary items
Exchange differences arise from:
The settlement of monetary items at a subsequent date to initial recognition;
and
Remeasuring an entity’s monetary items at rates different from those at which
they were initially recorded
Such exchange differences must be recognised as income or expenses in the period
in which they arise.
Exception:
Exchange difference are recognised directly in other comprehensive income in the
consolidated financial statements, if they arise on a monetary item that forms part of
a reporting entity’s net investment in a foreign operation denominated in the
functional currency of either the parent or the foreign operation.
Exchange differences on Non-Monetary items
When the gain or loss on a non-monetary item is recognised in profit or loss, any
exchange component of that gain or loss is also recognised in the profit or loss.
When the gain or loss on a non-monetary item is recognised directly in other
comprehensive income, any exchange component of that gain or loss is also
recognised directly in other comprehensive income.
Translation into Presentation currency
If the presentation currency is different from the functional currency then the results
and the financial position of an entity must be translated into the presentation
currency as follows:
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6. For each statement of financial position presented (including comparatives),
assets and liabilities are translated at the closing rate at the date of the
statement of financial position.
For each statement of comprehensive income or separate statement of
comprehensive income presented (including comparatives), income and
expenses are translated at exchange rates at the transaction dates (an
average rate for a period may be used unless rate fluctuates significantly).
Equity items are translated at the rate on the date of acquisition.
All resulting exchange differences are recognised in other comprehensive
income. These exchange differences are not recognised in income or
expenses for the period because the changes in the exchanges in the
exchange rates have little or no direct effect on the present or future cash
flows from entity’s operation. This is for translation into presentation currency
and not for initial recognition into functional currency.
Intra-group transaction
An intragroup monetary item (short or long term) cannot be eliminated against the
corresponding intragroup asset/liability without showing exchange differences in the
consolidated financial statements. In the consolidated financial statements, the
exchange differences stay as income or expenses unless they arise on a monetary
item forming part of reporting entity’s net investment in a foreign operation. While
translating the exchange gain or loss on such transaction use the average rate.
Goodwill and fair value transaction
Any goodwill arising on the acquisition of foreign operation and any fair value
adjustments to the carrying amount of assets and liabilities arising on the acquisition
of foreign operation are treated as:
Assets and liabilities of the foreign operation; and
Translated at the closing rate.
Disposal of foreign operation
On disposal of a foreign operation the cumulative translation amount of exchange
differences (CTD) that:
Have been recognised in other comprehensive income and accumulated in a
separate component of equity, and
Which relate to that foreign operation
Are reclassified from equity to profit or loss when the gains or loss on disposal are
recognised.
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7. In case of partial disposal all the accumulated translation reserves will be reclassified
into profit or loss.
When the carrying amount of a foreign operation is above its recoverable amount, a
write-down is required (e.g. evidenced by operating losses or impairment of assets).
Such write down does not constitute any kind of disposal, so no part of the deferred
foreign exchange gain or loss is recognised as income or expense.
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