Chapter 29

1. Chapter 29 Foreign currency translation

2. Contents • Introduction • Currency conversion • Currency translation • IAS 21 requirements for individual enterprise’s foreign currency transactions • Translation methods for financial statements of foreign operations • IAS 21 rules for translation of financial statements of foreign operations • Financial reporting in hyperinflationary economies

3. Learning objectives • Explain the necessity for foreign currency conversion and translation • Describe the IAS regulations in respect of foreign currency transactions for individual enterprises • Appraise the position where foreign currency investments and borrowings are matched • Critically appraise the IAS regulations in respect of translation of the accounts of foreign branches and subsidiaries etc. • Translate accounts of foreign enterprises • Describe the disclosure requirements of IAS regulations in respect of foreign currency translation

4. Currency conversion • Required when a foreign currency transaction is completed within an accounting period • Two events: • the purchase or sale of an asset or the incurring of an expense or item of income • the receipt or payment of monies for these assets, expenses or items of income • Example: • UK company sells goods to a Swiss company on 1 May 20X2 for SWFr 750 000. Payment on 1 August 20x2 Exchange rate 1 May 20X2: £1 = SWFr 3.5544 Exchange rate 1 August 20X2: £1 = SWFr 3.7081 Year end: 30 September 20X2; reporting currency: £

5. Currency conversion (cont’d) 01.05.20X2: 750 000 / 3.5544 = 211 006 Dr. Accounts receivable 211 006 Cr. Sales account 211 006 01.08.20X2: 750 000 / 3.7081 = 202 260 Dr. Cash 202 260 Cr. Accounts receivable 202 260 Acc. Receivables : £8 746 = loss on exchange (IS) In case exchange rate has decreased: profit on exchange

6. Currency conversion (cont’d) Year end 30 June 20X2; exchange rate £1= SWFr 3.6573 30.06.20X2: Acc. Receiv. would be £205 069 instead of £211 006 Difference of £5 937 loss of exchange (IS) 01.08.20X2: Payment of the debt: Further loss of £ 2 809 (so that total loss of £8 746 is split over two years)

7. Currency conversion (cont’d) • Loss of exchange on year end in income statement following the idea of prudence • Assume exchange rate £1 = 3.4973 • Year end acc. receivable = £214 451 • Profit on exchange = £3 445 • 1 August 20X2: loss of £12 191 • Gain of £3 445 is unrealized gain so that question arises whether or not to recognize this gain

8. IAS 21 requirements for individual enterprise’s foreign currency transactions • Exchange differences arising on the settlement of monetary items or on translating monetary items at rates different from those at which they were translated on initial recognition during the period, or in previous financial statements, should be recognized in profit or loss in the period in which they arise • When monetary items arise from a foreign currency transaction and there is a change in the exchange rate between the transaction date and the date of settlement, an exchange difference results. When the transaction is settled within the same accounting period as that in which it occurred, all the exchange difference is recognized in that period. However, when the transaction is settled in a subsequent accounting period, the exchange difference recognized in each period up to the period of settlement is determined by the change in exchange rates during each period • Thus, an unrealized gain to be recognized in the accounts

9. IAS 21 requirements (cont’d) • Activity 29.3: • 1.3.X2: Purchase of an asset: € 10.000 and exchange rate 1FC = 2€; functional currency is FC • 30.6.X2: balance sheet date: exchange rate 1FC = 1€ • monetary items: closing rate • non-monetary items carried at HC: exchange rate acquisition date • non-monetery items at fair value: exchange prevalent when FV was determined

10. IAS 21 requirements (cont’d) • Reporting currency • Functional currency : • currency of the primary economic environment in which the entity operates • Presentation currency • currency in which the financial statements are presented • Primary economic environment: • the one in which the entity primarily generates and expends cash

11. IAS 21 requirements (cont’d) • Factors to determine functional currency: • The currency: • that mainly influences sales prices for goods and services; and • of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services • The currency that mainly influences labour, material and other costs of providing goods or services • Following factors also provide evidence of functional currency: • the currency in which funds from financing activities are generated • the currency in which receipts from operating activities are usually retained

12. IAS 21 requirements (cont’d) • Additional factors: • whether the activities of the foreign operation are carried out as an extension of the reporting entity, rather than being carried out with a significant degree of autonomy • whether transactions with the reporting entity are a high or low proportion of the foreign operation’s activities • whether cash flows from the activities of the foreign operation directly affect the cash flows of the reporting entity and are readily available for remittance to it • whether cash flows from the activities of the foreign operation are sufficient to service existing and normally expected debt obligations without funds being made available by the reporting entity

13. IAS 21 requirements (cont’d) • Example: • An entity operating in France owns several buildings in Paris that are rented to foreign companies, mostly US companies. The lease contracts are determined in US dollars and payment can be made in either US dollars or Euros • Functional currency = EURO

14. IAS 21 requirements (cont’d) • A US entity has a foreign subsidiary located in Greece. The Greek subsidiary imports a product manufactured by its parent, paying in dollars, which it sells throughout Greece with selling prices denominated in Euros and determined primarily by local competition. The subsidiary’s long-term financing is primarily in the form of dollar loans from its parent and distribution of its profits is under parental control. Proceeds of the subsidiary are remitted to the parent on a regular basis • Functional currency = DOLLAR

15. IAS 21 requirements (cont’d) • Translation from functional to presentation currency occurs as follows: • assets and liabilities for each statement of financial position presented shall be translated at the closing rate at the date of that statement of financial position • income and expenses for each income statement shall be translated at exchange rates at the date of the transactions • all resulting exchange differences shall be recognized as a separate component of equity

16. IAS 21 requirements (cont’d)

17. IAS 21 requirements (cont’d)

18. IAS 21 requirements (cont’d)

19. IAS 21 requirements (cont’d) • Loans • translated as any other monetary item at closing rate and the exchange gain or loss credited or charged to income • Investments matched by borrowings • an asset, exposed to an exchange risk • a liability also exposed to an exchange risk • since asset and liability part of one overall transaction, effects of exchange rate movements cancelled out • Hedge accounting • allowance to classify exchange differences as equity arisen on a foreign currency liability used as hedge

20. IAS 21 requirements (cont’d) • Summary of individual enterprise transactions: • Settled transactions: gain or loss is obviously realized and reflected in cash flows • Unsettled transactions: short-term monetary items translate at year end exchange rate and gain or loss, although unrealized, is taken to statement of income, as it is reasonably certain • Long-term monetary items treated the same as short term • If a liability forms a hedge to a net investment then the exchange difference on the liability is classified as equity

21. Translation methods for financial statements of foreign operations • Two basic possible views: • we can use the exchange rate ruling when the item was created (historic rate) • we can use the exchange rate ruling when the item is being reported (current or closing rate) • Different combinations: • Single rate (closing rate) • all assets, liabilities, revenues, expenses: closing rate • Mixed rate (current/non current) • current assets and liabilities: closing rate • fixed assets and non-current liabilities: rate ruling when the item was established

22. Translation methods etc (cont’d) • Mixed rate (monetary/non monetary) • monetary assets and liabilities: closing rate • all non-monetary assets and liabilities: rate ruling when the item was established • Mixed rate (temporal) • assets recorded at HC: historic rate (rate ruling when the item was established) • assets recorded on a current value: closing rate • revenues and expenses: rate ruling on the date when the amount shown in the accounts was established

23. IAS 21 Rules for translation of financial statements of foreign operations • Determine functional currency • Translate foreign currency into functional currency using temporal method • Exchange differences in P&L • Translate functional currency in foreign currency when necessary

24. IAS 21 Rules for translation etc (cont’d)

25. IAS 21 Rules for translation etc (cont’d)

26. IAS 21 Rules for translation etc (cont’d) Home established a 100% ownership of Away on 1 January year 8 by subscribing to €25 000 of shares in cash when the exchange rate was 12 ‘tickets’ to the €. Away raised a long-term loan of 100 000 tickets locally on 1 January year 8 and immediately purchased equipment costing 350 000 tickets, which was expected to last ten years with no residual value. It was to be depreciated under the straight line method. The accounts of Away in the foreign currency for year 8 follow, during which the relevant exchange rates were: Tickets to € 1 January 12 Average for year 11 Average for period in which closing inventory acquired 10.5 31 December 10

27. IAS 21 Rules for translation etc (cont’d)

28. IAS 21 Rules for translation etc (cont’d)

29. IAS 21 Rules for translation etc (cont’d)

30. IAS 21 Rules for translation etc (cont’d) • Some other issues: • Disposal: • The cumulative amount of the exchange differences deferred in the separate component of equity relating to that foreign operation should be recognized in profit or loss • Change in entity’s functional currency: • Generally: not allowed • Except when change in the underlying transaction events or conditions (e.g. adoption of the euro) • Translation into new functional currency at exchange rate of the date of change; resulting translated amounts for non-monetary items treated at their historical cost • Disclosure requirements (see IAS 21, paras 51–57)

31. Financial reporting in hyperinflationary economies • Financial statements have to be dealt with in accordance with IAS 29 before IAS 21 is applied • stated in the measuring unit current at the statement of financial position date • GAAP comparisons: • IAS v UK • FRS 23 convergent with IAS 21 • IAS v US • SFAS 52 similar to IAS 21

32. For individual entity transactions non-monetary items are translated at originating exchange rate but monetary items at statement of financial position rate if not settled. Thus unrealised gains and losses due to foreign currency fluctuations will be taken to the statement on income generally as part of ordinary activities Foreign entities recording to functional currency use the temporal method Foreign entities translating to presentation currency use the closing rate for statement of financial position and average rate for statement of income. Where exchange differences result from severe devaluations and there is no practical means to hedge, these are carried as part of the cost of the asset. Summary

33. Foreign operations in hyperinflationary economies have to be stated in the measuring unit current at the statement of financial position date before translation IFRIC 16, Hedges of a net investment in a foreign operation – was issued in July 2008 and should be referenced for further guidance on hedging Summary contd.