IAS 21 - Foreign currency

1. IAS 21 - Foreign currency

2. Executive summary • IFRS and US GAAP are quite similar in their approach to foreign currency translation. • Both IFRS and US GAAP require the adoption of functional currencies for foreign subsidiaries, although a somewhat different evaluation approach is followed to determine functional currency. • Both IFRS and US GAAP require that the exchange gain or loss from foreign currency transactions be reflected in the statement of income. • Both IFRS and US GAAP require (if necessary) remeasurement into the functional currency before translation into the reporting currency. The two approaches to this remeasurement are generally the same, with both requiring that remeasurement gains and losses be reported in the statement of income.

3. Executive summary • The methods of translating financial statements from the functional currency to the reporting currency are similar under IFRS and US GAAP. Both IFRS and US GAAP use a currency translation account (CTA) for translation differences. The CTA is included in other comprehensive income under both IFRS and US GAAP. • Consolidation of foreign operations may be different under IFRS and US GAAP. IFRS allows either the step-by-step approach or the indirect approach, whereas US GAAP requires the step-by-step approach.

4. Progress on convergence There are currently no convergence projects underway or planned for foreign currency matters.

5. Functional currency US GAAP IFRS Functional currency is defined as the currency of the primary economic environment in which a company operates and which is normally the currency in which a company primarily generates and expends cash. Similar Assets, liabilities, and operations of an entity should be measured using the functional currency of that entity. Similar Subsequent to conversion to a functional currency and generally subsequent to a multinational company’s consolidation, both US GAAP and IFRS allow financial statements to be presented in a currency other than the functional currency. This is referred to as a reporting currency. Similar

6. Functional currency US GAAP • The following economic factors, and possibly others, should be considered both individually and collectively when determining the functional currency: • Cash flow currency • Location of the factors that affect sales prices • Location of the sales market • Expenses – where goods and services are acquired • The primary currency in which financing is denominated • Volume of intercompany transactions and arrangements IFRS • There are primary factors and secondary factors to consider. The secondary factors are to be used only when the determination of the functional currency using the primary factors produces mixed results. The primary factors to be considered in determining the functional currency are: • The currency that influences its sales prices, which will often be the currency in which the sales prices for its goods and services are denominated and settled and the currency of the country whose competitive forces or regulations determine these sales prices. • The currency that mainly influences labor, material and other costs of providing goods and services.

7. Functional currency US GAAP IFRS • The secondary factors, which are to be used only when the determination of the functional currency using the primary results produces mixed results, are: • The currency of financing: the currency in which operating cash flows are retained. • Activities carried out as an extension of the reporting entity. • Proportion of foreign operation’s transactions with reporting entity. • Cash flows directly affect cash flows of reporting entity and are readily available for remittance to it. • Cash flows sufficient to service existing and normally expected debt obligations without funds being made available by the reporting entity. Despite these varying factors for determining the functional currency of an entity and the fact that IFRS requires that primary factors be considered prior to considering the secondary factors, it is expected that under both methods the answer to the functional currency conclusion will be the same.

8. Summary of factors considered in determining functional currency

9. Example 1 A US-based company by the name of Big Blue owns 100% of Big Blue UK. The functional currency of Big Blue is the US Dollar (USD) and the functional currency of Big Blue UK is the British pound (GBP). The USD is also the reporting currency of the consolidated group. Determining functional currency example Big Blue UK is a leading provider of Tudor-style ceramic pottery replicas, which are sold at the finest tourist shops throughout London. However, with the interest in Henry VIII rising in the US, in 2008, Big Blue UK began exporting its products to the US. Total exports accounted for 10% of the total sales. The ceramic pottery replicas are made in Wales using clay from quarries in northern Scotland. • Based on the above, what is the functional currency of Big Blue UK under US GAAP and IFRS?

10. Example 1 solution: US GAAP: The functional currency of Big Blue UK is the GBP. Under US GAAP, an entity’s functional currency is the currency of the primary economic environment in which the entity operates; normally, that is the currency of the environment in which an entity primarily generates and expends cash. Based on the six criteria found in US GAAP (with none being of higher importance), Big Blue UK generates most of its cash flows in GBP. In addition, most of its sales are transacted in GBP and influenced by local forces. Its goods and services are acquired in the UK. IFRS: Based upon the available primary indicators, the GBP is the functional currency. This is because the GBP mainly influences the sales prices of goods, labor, materials, other costs of providing goods and the competitive forces and regulations that mainly determine the sales prices of the goods. Thus, it is not necessary to utilize the secondary factors under IFRS. Even though the factors that an entity must consider to determine its functional currency are set up differently under IFRS and US GAAP, the two sets of standards result in the same determination of the functional currency. Determining functional currency example

11. Foreign currency transactions US GAAP IFRS Foreign currency transactions are transactions denominated in a currency other than the entity’s functional currency. Similar Foreign exchange gains or losses generally should be included in income for the period in which the exchange rate changes. Similar At each balance sheet date and upon settlement, recorded foreign currency monetary balances should be adjusted to reflect current exchange rates. Similar

12. Foreign currency transactions There are no significant differences in recording financial currency transactions. The important point is to determine the proper functional currency because differences in functional currencies can cause differences in the exchange gains or losses recorded.

13. Translation of foreign currency financial statementsTranslation (remeasurement) into functional currency US GAAP IFRS Requires remeasurement into the functional currency before translation into the reporting currency, if necessary. Typically this translation involves translating a foreign subsidiary’s financial statements into the parent’s reporting currency. Similar

14. Translation of foreign currency financial statementsTranslation (remeasurement) into functional currency US GAAP IFRS • The method used to remeasure the financial statements into the functional currency is: • Monetary assets and all liabilities are translated at the period-end rates. • All other assets are translated at the historical rates as of the date of acquisition (or the date of the investment of the subsidiary if the assets were already owned as of the investment date). • Income statement items that can be specifically identified with a date of acquisition are translated using the historical rate at acquisition (e.g., cost of goods sold since inventory can be identified with a date of acquisition). • Other Income statement amounts are generally translated at a weighted-average rate for the period. Similar

15. Translation of foreign currency financial statementsTranslation (remeasurement) into functional currency US GAAP IFRS • Remeasurement method (continued): • Equity components, other than retained earnings, are translated at historic rates (based on the date of investment in the subsidiary). • Retained earnings are translated in layers, as follows: • Retained earnings that existed at the date of investment are translated at historic rates (based on the date of investment in the subsidiary). • Income additions to retained earnings since the date of investment are translated using the weighted-average rate, as are income items. • Dividend reductions to retained earnings are translated using the historical rates at the date of declaration of the dividend. • The remeasurement gain/loss is included in the statement of income for the period. Similar

16. Translation of foreign currency financial statementsTranslation (remeasurement) into functional currency There are some differences between US GAAP and IFRS in remeasuring the functional currency into the reporting currency in hyperinflationary economies.

17. Overview of translation (remeasurement) into functional currency Remeasurement of foreign currency Translation of foreign currency 1 US Parent The functional currency is the US dollar 2 Foreign entity The financial records are maintained in functional currency Foreign entity The financial records are not maintained in functional currency The foreign entity’s financial records should be translated to a functional currency with gains or losses recognized in income and the functional currency financial statements (if not in US dollars) are translated to US dollars and gains and losses are recognized in OCI (currency translation account). The foreign entity’s financial records in functional currency are translated to US dollars and gains and losses are recognized in OCI (currency translation account). 1 2

18. Translation of foreign currency financial statementsTranslation of a foreign entity’s functional currency into a reporting currency US GAAP IFRS • The following method used to translate financial statements from the functional currency to the reporting currency: • Assets and liabilities are translated to the reporting currency at the period-end rates. • Statement of income and cash flow amounts are generally translated at a weighted-average rate for the period. • Equity components, other than retained earnings, are translated at historic rates (based on the date of investment in the subsidiary). Similar, with the exception of the translation of financial statements in hyperinflationary economies.

19. Translation of foreign currency financial statementsTranslation of a foreign entity’s functional currency into a reporting currency US GAAP IFRS • Translation method (continued): • Retained earnings are translated in layers as follows: • Retained earnings that existed at the date of investment are translated at historic rates (based on the date of investment in the subsidiary). • Income additions to retained earnings since the date of investment are translated using the weighted-average rate, as is done for income items. • Dividend reductions to retained earnings are translated using the historical rates at the date of declaration of the dividend. Similar, with the exception of the translation of financial statements in hyperinflationary economies.

20. Translation of foreign currency financial statementsTranslation of a foreign entity’s functional currency into a reporting currency US GAAP IFRS The net translation gain/loss is not included in income, but rather such gains/losses are accumulated in OCI as a CTA. Similar Requires certain foreign exchange effects related to net investments in foreign operations to be accumulated in shareholders’ equity (CTA) instead of recording them in net income as they arise. Similar

21. Translation of foreign currency financial statementsTranslation of a foreign entity’s functional currency into a reporting currency – CTA US GAAP IFRS The CTA, presented in OCI, reflects the translation gains and losses not included in the determination of net income and any differences from hedging instruments. Similar The CTA in OCI is recorded into income in the same period as the gain or loss on disposal of the investment in the foreign operation. Disposal includes sale of 100% or a portion of the subsidiary, the repayment of share capital, or abandonment. Similar

22. Translation of foreign currency financial statementsTranslation of a foreign entity’s functional currency into a reporting currency – CTA US GAAP • No similar requirement. • When assessing impairment of a disposal group that includes a foreign operation, an entity is required to add or deduct the CTA related to that foreign operation to or from the carrying amount of the investment. IFRS • Amounts in the CTA are taken into income when two other events take place: (1) A subsidiary pays dividends in excess of earnings. (2) Long-term advances are repaid. • No similar requirement, which may result in differences in impairment charges.

23. Example 2 The New Coachworks Company, a US-based company, owns 100% of its UK subsidiary, Old Coachworks Company. The companies follow a calendar year for financial reporting purposes. On September 30, 2010, Old Coachworks paid dividends of GBP 100,000 ($150,000 USD) to New Coachworks which was GBP 10,000 in excess of Old Coachworks’ share of earnings retained by Old Coachworks. The GBP represents a 10% return of investment to New Coachworks and the CTA balance at September 30, 2010, is $15,000, which represents CTA layers for 2007, 2008 and 2009 of $4,000 per year and $3,000 through September 30, 2010. Disposal of an investment example On November 1, 2010, New Coachworks decided to sell 60% of its investment in Old Coachworks to a third party in a cash transaction. At year-end, the disposal is considered held for sale, but is not expected to close until March 2011. The CTA totals $16,000 as of year-end. The functional currency of Old Coachworks is the GBP and the currency of New Coachworks is the USD. Currency translation adjustments (CTAs) have been recorded in New Coachworks’ consolidated financial statements with respect to Old Coachworks.

24. Disposal of an investment example • Does the payment of dividends of GBP 100,000 ($150,000 USD) by Old Coachworks to New Coachworks have any effect on New Coachworks’ CTA at the time of the dividends payment, September 30, 2010? Describe the treatment under US GAAP and IFRS. • Describe the effect the disposal will have on the CTA of New Coachworks under both US GAAP and IFRS. • At December 31, 2010, New Coachworks has classified Old Coachworks as held for sale. Does this classification affect impairment testing that will be done as of year-end? Describe your conclusions under US GAAP and IFRS.

25. Example 2 solutions: Payment of dividends US GAAP: The translation difference (CTA) in equity is not recognized when there is a partial return of the investment to the parent. The dividends would be recognized in the statement of income at the translated amount. IFRS: A return on investment (dividends that exceed the retained earnings of Old Coachworks by GBP 10,000) is treated as a partial disposal of the foreign investment, and a proportionate share of the translation difference (10% x $15,000 = $1,500) is recognized in the statement of income. Disposal of an investment example

26. Example 2 solutions (continued): Disposal US GAAP:The disposal of Old Coachworks should be recorded in March 2011, when it is sold. The translation difference in equity (CTA) related to the portion sold, 60% (60% x $16,000 = $9,600), would be recognized in the statement of income of New Coachworks upon the completion of the sale. Thus, in March 2011, New Coachworks would transfer $9,600 of the existing related CTA from OCI and into the statement of income as a gain/loss on disposal. IFRS: The treatment is the same as under US GAAP. However, the amount of CTA recognized will differ from US GAAP due to the amount of dividends received in September 2010. If there is a 10% return of equity at September 30, 2010 (10% x $15,000 = $1,500), then the $1,500 would be reversed from CTA and recognized in the statement of income at that time. Thus the remaining translation difference in equity (CTA) related to the portion sold, 60% (60% x 14,500 = $8,700), would be recognized in income of New Coachworks upon the completion of the sale. In March 2011, New Coachworks would transfer 8,700 of the existing related CTA from OCI and into the income statement as a gain/loss on disposal. Disposal of an investment example

27. Disclosures US GAAP IFRS • Requires the disclosure of: • Aggregate translation gains or losses included in income. • Analysis of changes in the CTA for the period, including the effects of income taxes. Similar

28. Consolidation of foreign operations US GAAP • Does not have this requirement. • Does not have this requirement. IFRS • Requires that when the presentation currency is different from the functional currency, that fact and the reasons for using a different presentation currency shall be disclosed . • Requires that when there is a change in the functional currency of either the reporting entity or a significant operation, that fact shall be disclosed.