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IAS 21, The effects of changes in foreign

exchange rates

By Graham Holt

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The purpose of IAS 21 is to set out how to account for transactions in foreign currencies and

foreign operations.

The standard shows how to translate financial statements into a presentation currency, which isthe currency in which the financial statements are presented. This contrasts with the functionalcurrency, which is the currency of the primary economic environment in which the entityoperates. Key issues are the exchange rates, which should be used, and where the effects ofchanges in exchange rates are recorded in the financial statements.

Functional currency is a concept that was introduced into IAS 21, The Effects of Changes inForeign Exchange Rates, when it was revised in 2003. The previous version of IAS 21 used aconcept of reporting currency. In revising IAS 21 in 2004, the IASBs main aim was to provide

additional guidance on the translation method and determining the functional and presentationcurrencies.

The functional currency should be determined by looking at several factors. This currency shouldbe the one in which the entity normally generates and spends cash, and that in which transactionsare normally denominated. All transactions in currencies other than the functional currency aretreated as transactions in foreign currencies.

The entitys functional currency reflects the transactions, events and conditions under which theentity conducts its business. Once decided on, the functional currency does not change unlessthere is a change in the underlying nature of the transactions and relevant conditions and events.

Foreign currency transactions should initially be recorded at the spot rate of exchange at the dateof the transaction. An approximate rate can be used. Subsequently, at each balance sheet date,foreign currency monetary amounts should be reported using the closing rate. Non-monetaryitems measured at historical cost should be reported using the exchange rate at the date of thetransaction. Non-monetary items carried at fair value, however, should be reported at the ratethat existed when the fair values were determined.

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Exchange differences arising on monetary items are reported in profit or loss in the period, withone exception. The exception is that exchange differences arising on monetary items that formpart of the reporting entitys net investment in a foreign operation are recognised in the groupfinancial statements, within a separate component of equity. They are recognised in profit or losson disposal of the net investment. If a gain or loss on a non-monetary item is recognised in

equity (for example, property, plant and equipment revalued under IAS 16), any foreignexchange gain or loss element is also recognised in equity.

Presentation currency and functional currency

An entity can present its financial statements in any currency. If the presentation currency differsfrom the functional currency, the financial statements are retranslated into the presentationcurrency. If the financial statements of the entity are not in the functional currency of ahyperinflationary economy, then they are translated into the presentation currency as follows:

y Assets and liabilities (including any goodwill arising on the acquisition and any fair valueadjustment) are translated at the closing spot rate at the date of that balance sheet

y Income statements are translated at the spot rate at the date of the transactions (averagerates are allowed if there is no great fluctuation in the exchange rates)

y All exchange differences are recognised in a separate component of equity.At the entity level, management should determine the functional currency of the entity based onthe requirements of IAS 21.

An entity does not have a choice of functional currency. All currencies, other than the functionalone, are treated as foreign currencies. An entitys management may choose a different currencyfrom its functional one the presentation currency in which to present financial statements.

At the group level, various entities within a multinational group will often have differentfunctional currencies. The functional currency is identified at entity level for each group entity.Each group entity translates its results and financial position into the presentation currency of thereporting entity.

Normal consolidation procedures are followed for the preparation of the consolidated financialstatements, once all the consolidated entities have prepared their financial information in theappropriate presentation currency.

Translation of a foreign operation

When preparing group accounts, the financial statements of a foreign subsidiary should betranslated into the presentation currency as set out above. Any goodwill and fair valueadjustments are treated as assets and liabilities of the foreign entity, and therefore retranslated ateach balance sheet date at the closing spot rate.

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Exchange differences on intra-group items are recognised in profit or loss, unless they are aresult of the retranslation of an entitys net investment in a foreign operation when it is classifiedas equity.

Dividends paid in a foreign currency by a subsidiary to its parent firm may lead to exchange

differences in the parents financial statements. They will not be eliminated on consolidation, butrecognised in profit or loss. When a foreign operation is disposed of, the cumulative amount ofthe exchange differences in equity relating to that foreign operation is recognised in profit or losswhen the gain or loss on disposal is recognised.

Conclusion

The notion of a group functional currency does not exist under IFRS; functional currency ispurely an individual entity or business operation-based concept. This has resulted in IAS 21becoming one of the more complex standards for firms converting to IFRS.

In addition, many multinational groups have found the process time-consuming and challenging,particularly when considering non-trading group entities where the standards emphasis onexternal factors suggests that the functional currency of corporate subsidiaries might well be thatof the parent, regardless of their country of incorporation or the currency in which theirtransactions are denominated.

Entities applying IFRS need to remember that the assessment of functional currency is a key stepwhen considering any change in the group structure or when implementing any new hedging ortax strategies. Furthermore, should the activities of the entity within the group change for anyreason, the determination of the functional currency of that entity should be reconsidered toidentify the changes required. Management must take care to document the approach followed in

the determination of functional currency for each entity within the group, using a consistentmethodology across all cases, particularly when an exercise of judgment is required.

Case study 1

An entity, with the dollar as its functional currency, purchases plant from a foreign entity for18m on 31 May 2008 when the exchange rate was 2 to $1. The entity also sells goods to aforeign customer for 10.5m on 30 September 2008, when the exchange rate was 1.75 to $1. Atthe entitys year end of 31 December 2008, both amounts are still outstanding and have not been

paid. The closing exchange rate was 1.5 to $1.

The accounting for the items for the period ending 31 December 2008 would be as follows:

The entity records the plant and liability at $9m at 31 May 2008. At the year-end, the amount hasnot been paid. Thus using the closing rate of exchange, the amount payable would be retranslatedat $12m, which would give an exchange loss of $3m in profit or loss. The asset remains at $9mbefore depreciation.

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The entity will record a sale and trade receivable of $6m. At the year-end, the trade receivablewould be stated at $7m, which would give an exchange gain of $1m that would be reported inprofit or loss. IAS 21 does not specify where exchange gains and losses should be shown in thestatement of comprehensive income.

Case study 2

An entity has a 100%-owned foreign subsidiary, which has a carrying value at a cost of $25m. Itsells the subsidiary on 31 December 2008 for 45m. As at 31 December 2008, the credit balanceon the exchange reserve, which relates to this subsidiary, was $6m. The functional currency ofthe entity is the dollar and the exchange rate on 31 December 2008 is $1 to 1.5. The net assetvalue of the subsidiary at the date of disposal was $28m.

The subsidiary is sold for $45m divided by 1.5 million, therefore $30m. In the parent entitys

accounts a gain of $5m will be shown. In the group financial statements, the cumulativeexchange gain in reserves will be transferred to profit or loss, together with the gain on disposal.The gain on disposal is $30m minus $28m, therefore $2m, which is the difference between thesale proceeds and the net asset value of the subsidiary. To this is added the exchange reservebalance of $6m to give a total gain of $8m, which will be included in the group statement ofcomprehensive income.

Graham Holt is an ACCA examiner and principal lecturer in accounting and finance atManchester Metropolitan University Business School

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