IAS 21

IAS 21: Effects of Changes in Foreign Exchange Rates

IAS 21 deals with two situations where foreign currency impacts financial statements:

• An entity which buys or sells goods overseas, priced in a foreign currency transaction
• The translation of foreign currency subsidiary financial statements prior to consolidation

Functional Currency

An entity is required to determine a functional currency (for each of its operations if necessary) based on the primary economic environment in which it operates, and generally records foreign currency transactions using the spot conversion rate to that functional currency on the date of the transaction.

The functional currency is the currency of the primary economic environment in which the entity operates and it is normally the currency in which the entity primarily generates and expends cash.

Indicators

Indicators of functional currency, include:

• The currency that mainly influences sales prices for goods and services
• The currency 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
• The currency in which funds from financing activities are generated
• The currency in which receipts from operating activities are usually retained

Further indicators of the functional currency of foreign operations, include:

• Whether the foreign operation carries out its business as though it were an extension of the reporting entity rather than with a significant degree of autonomy
• Whether transactions with the parent are a high or a 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 parent 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

Foreign Currency Transactions

Initial Recognition

• An entity is required to recognise foreign currency transactions in its functional currency.

• The entity should achieve this by translating the foreign currency amount at the spot exchange rate between the functional currency and the foreign currency at the date on which the transaction took place

• The date of the transaction is the date on which the transaction first met the relevant recognition criteria

Average Rate

• Where an entity has a high volume of transactions in foreign currencies, translating each transaction may be an onerous task, so an average rate may be used.
• For example, a duty-free shop at Heathrow airport may receive a large amount of dollars and euros every day and may opt to translate each currency into sterling using an average weekly rate.
• An average rate should not be adopted if exchange rates or underlying transactions fluctuate significantly (eg due to seasonality), because in this case an average rate is not a good approximation.

Subsequent Measurement

A foreign currency transaction may give rise to assets or liabilities that are denominated in a foreign currency.

These assets and liabilities will need to be translated into the entity’s functional currency at each reporting date.

This will depend on whether the assets or liabilities are monetary or non-monetary items.

Monetary items

The essential feature of a monetary item, as the definition implies, is the right to receive (or an obligation to deliver) a fixed or determinable number of units of currency. Examples of monetary assets include:

• Cash and bank balances
• Trade receivables and payables
• Loan receivables and payables
• Foreign currency bonds held as available for sale
• Foreign currency bonds held to maturity
• Pensions and other employee benefits to be paid in cash
• Provisions that are to be settled in cash
• Cash dividends that are recognised as a liability

Foreign currency monetary items outstanding at the end of the reporting date shall be translated using the closing rate.

The difference between this amount and the previous carrying amount in functional currency is an exchange gain or loss.

Non-monetary items

A non-monetary item does not give the right to receive or create the obligation to deliver a fixed or determinable number of units of currency. Examples of non-monetary items include:

• Amounts prepaid for goods and services (eg prepaid rent)
• Goodwill
• Intangible assets
• Inventories
• Property, plant and equipment
• Provisions to be settled by the delivery of a non-monetary asset
• Equity instruments that are held as fair value through other comprehensive income - without recycling (FVOCI)
• Equity investments in subsidiaries, associates or joint ventures

Non-monetary items carried at historic cost are translated using the exchange rate at the date of the transaction when the asset arose (historical rate).

They are not subsequently retranslated in the individual financial statements of the entity.

Non-monetary items carried at fair value are translated using the exchange rate at the date when the fair value was determined. (fair value date)

The foreign currency fair value of a non-monetary asset is determined by the relevant Standards (eg IAS 16 for property, plant and equipment and IAS 40 for investment property).

Issues in the measurement of non-monetary assets

Subsequent depreciation should be translated on the same basis as the asset to which it relates

• the rate at the date of acquisition for assets carried at cost, and at the rate at the last valuation date for assets carried at revalued amounts

With IAS 2 Inventories. The carrying amount in the functional currency is determined by comparing:

• The cost, translated at the exchange rate at the date when that amount was determined
• The net realisable value, translated at the exchange rate at the date when that net realisable value was determined (eg the closing date at the reporting date).

Financial Assets

Initial Measurement

Financial assets can be monetary or non-monetary, and may be carried at fair value, or amortised cost

Where a financial instrument is denominated in a foreign currency, it is initially recognised at fair value in the foreign currency and translated into the functional currency at spot rate.

Subsequent Measurement

At each year end, the foreign currency amount of financial instruments carried at amortised cost is translated into the functional currency using either the closing rate (if it is a monetary item) or the historical rate (if it is a non-monetary item).

Financial instruments carried at fair value are translated to the functional currency using the closing spot rate.

Recognition

The entire change in the carrying amount of a non-monetary fair value through other comprehensive income financial asset (e.g. FVOCI - without recycling), including the effect of changes in foreign currency rates, is reported as other comprehensive income at the reporting date. This would be done, for example, for most equity instruments.

A change in the carrying amount of a monetary fair value through other comprehensive income financial asset (e.g. FVOCI - with recycling) on subsequent measurements is analysed between the foreign exchange component, and the fair value movement.

The fair value movement is recognised as other comprehensive income and the foreign exchange component is recognised in profit or loss (based on the asset’s amortised cost). This would be done, for example, for debt instruments.

The entire change in the carrying amount of financial instruments measured at fair value through profit or loss (FVTPL), including the effect of changes in foreign currency rates, is recognised in profit or loss.

Exchange differences on Transactions

Exchange differences arise:

• On retranslation of a monetary item at the year end
• Settlement of a monetary item in cash (eg a foreign currency payable is paid)
• Impairment, revaluation or other fair value change in a non-monetary item

Monetary items

Where a monetary item arising from a foreign currency transaction remains outstanding at the reporting date, an exchange difference arises, being the difference between:

• Initially recording the item at the rate ruling at the date of the transaction (or when it was translated at a previous reporting date), and
• The subsequent retranslation of the monetary item to the rate ruling at the reporting date.

Such exchange differences should be reported as part of the profit or loss for the year.

Settlement of monetary items

Exchange differences arising on the settlement of monetary items (receivables, payables, loans, cash in a foreign currency) should be recognised in profit or loss in the period in which they arise.

There are two situations to consider:

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

Exceptions to the general rule

Exchange differences should normally be recognised as part of profit or loss for the period

In the following cases the exchange differences on monetary items are not reported in profit or loss because hedge accounting provisions overrule the regulations of IAS 21.

• A monetary item designated as a hedge of a net investment in consolidated financial statements. In this case any exchange difference that forms part of the gain or loss on the hedging instrument is recognised as other comprehensive income.
• A monetary item designated as a hedging instrument in a cash flow hedge. In this case any exchange difference that forms part of the gain or loss on the hedging instrument is recognised as other comprehensive income.
• Exchange differences arising in respect of monetary items which are part of the net investment in a foreign operation are recognised in profit or loss in the individual financial statements of the entity or foreign operation as appropriate. However, in the consolidated statement of financial position the exchange differences are recognised in equity. This exemption arises only on consolidation

Non-monetary items

Where a non monetary item (e.g. inventory or a non-current asset) is recognised at historical cost (and there is no impairment) then it is translated into the functional currency at the exchange rate on the date of the transaction.

It is not then retranslated at subsequent reporting dates in the individual financial statements of the entity, and therefore no exchange differences arise

Exchange differences do however arise on non-monetary items when there has been a change in their underlying value (e.g. fair value changes, revaluations, or impairments). As non-monetary assets, any fx difference is not recognised separately, but as follows:

• When a gain or loss on a non-monetary item is recognised as other comprehensive income (for example, where property denominated in a foreign currency is revalued) any related exchange differences should also be recognised as other comprehensive income.
• When a gain or loss (e.g. fair value change) on a non-monetary item is recognised in profit or loss, any exchange component of that gain or loss is also recognised in profit or loss.

Foreign Currency Translations

Translation wtih a non-hyper inflationary currency

The following procedures should be followed to translate an entity’s financial statements from its functional currency into a presentation currency:

1. Translate all assets and liabilities (both monetary and non monetary) in the current statement of financial position using the closing rate at the reporting date.
2. Translate income and expenditure in the current statement of comprehensive income using the exchange rates ruling at the transaction dates. Often, an approximation to actual rate is normally used, being the average rate.
3. Report the exchange differences which arise on translation as other comprehensive income (in both the foreign subsidiary and consolidated statements).
4. Where a foreign subsidiary is not wholly-owned, allocate the relevant portion of the exchange differences to the non-controlling interest.

Translation of equity

No guidance is provided as to how amounts in equity should be translated. Using the closing rate would be consistent with the approach to the translation of assets and liabilities.

Translation at historical rates may seem more appropriate, given the one-off, capital nature of such items such as share capital.

As IAS 21 is not explicit in this respect, either approach may be adopted, although an entity should follow a consistent policy between periods.

Exchange differences on Translations

The exchange differences comprise:

• Differences arising from the translation of the statement of comprehensive income at exchange rates at the transaction dates or at average rates and the translation of assets and liabilities at the closing rate.
• Differences arising on the opening net assets’ retranslation at a closing rate that differs from the previous closing rate.

Resulting exchange differences are reported as other comprehensive income and classified as a separate component of equity, (in both the foreign subsidiary and consolidated statements) - as such differences have not resulted from exchange risks to which the entity is exposed, but purely through changing the currency in which the financial statements are presented.

To report such exchange differences in profit or loss would distort the results from the trading operations, as shown in the functional currency financial statements, since these differences are unrelated to the foreign operation’s trading performance or financial operation.

Net Investments in a foreign operation

The requirement in an entity’s own financial statements to recognise in profit or loss all exchange differences in respect of monetary items which are part of an entity’s net investment in a foreign operation is explained earlier, above.

On consolidation, however, the differences should be recognised as other comprehensive income and recorded in a separate component of equity.

This treatment is required because exchange differences arising from the translation of the operations’ net assets will move in the opposite way.

If there is an exchange loss on the net investment, there will be an exchange gain on the net assets, and vice versa.

The two movements should be netted off, rather than one being recognised in profit or loss and the other as other comprehensive income.

When a monetary item is part of the net investment in a foreign operation (ie there is an intra group loan outstanding) then the following rules apply on consolidation.

• If the monetary item is denominated in the functional currency of the parent entity the exchange difference will be recognised in the profit or loss of the foreign subsidiary.
• If the monetary item is denominated in the functional currency of the subsidiary, exchange differences will be recognised in the profit or loss of the parent entity
• When the monetary item is denominated in the functional currency of either entity, on consolidation, the exchange difference will be removed from the consolidated profit or loss and it will be recognised as other comprehensive income and recorded in equity in the combined statement of financial position.
• If, however, the monetary item is denominated in a third currency which is different from either entity’s functional currency, then the translation difference should be recognised as part of profit or loss.
  • For example, the parent may have a functional currency of US dollars, the foreign operation a functional currency of Euros, and the loan made by the foreign operation may have been denominated in UK sterling.
  • In this scenario, the exchange difference results in a cash flow difference and should be recognised as part of the results of the group.

A separate foreign currency reserve reported as part of equity may have a positive or negative carrying amount at the reporting date. Negative reserves are permitted under IFRS.

Disposal of a foreign operation

When a foreign operation is disposed of, the cumulative amount of the exchange differences recognised in other comprehensive income and accumulated in the separate component of equity relating to that foreign operation shall be recognised in profit or loss when the gain or loss on disposal is recognised.

Disposal may occur either through sale, liquidation, repayment of share capital or abandonment of all, or part of, the entity. The payment of the dividend is part of a disposal only if it constitutes a return of the investment; for example, when the dividend is paid out of pre-acquisition profits. In the case of a partial disposal, only the proportionate share of the related accumulated exchange difference is included in the gain or loss. A write-down of the carrying amount of a foreign operation does not constitute a partial disposal. Accordingly, no part of the deferred foreign exchange gain or loss is recognised in profit or loss at the time of a write-down.

Intra-group trading transactions

Where normal trading transactions take place between group companies located in different countries, the transactions give rise to monetary assets or liabilities that may either have been settled during the year or remain unsettled at the reporting date.

Inter-company dividends

Dividends paid in a foreign currency during a period by a subsidiary to its parent may lead to exchange differences being reported in the parent’s financial statements. This will be the case where the dividend is recognised at the transaction date, being the date on which the parent recognises the receivable, but receipt is not until a later date and exchange rates have moved during this period. As with other intra-group exchange differences, these amounts should not be eliminated on consolidation.

Goodwill and Fair Value adjustments

Goodwill

Goodwill arising under IFRS 3 Business Combinations from the acquisition of a foreign operation should initially be calculated in the functional currency of the subsidiary and then be treated as an asset of the foreign operation and translated at the closing rate each year.

The exchange difference arising is recorded as other comprehensive income in the consolidated accounts and accumulated in group equity.

The carrying amount of goodwill in the presentation currency is therefore as affected by changes in exchange rates as any other non-current asset.

Fair Value

Adjustments made to the fair values of assets and liabilities of a foreign operation under IFRS 3 should be treated in the same way as goodwill.

The adjustments are recognised in the carrying amounts of the assets and liabilities of the foreign operation in its functional currency. The adjusted carrying amounts are then translated at the closing rate.

Non-Controlling interest

The figure for non-controlling interests in the statement of financial position will be the appropriate proportion of the translated share capital and reserves of the subsidiary plus, where the NCI is valued at fair value, its share of goodwill translated at the closing rate.

The non-controlling interest in profit or loss will be the appropriate proportion of profits available for distribution. If the functional currency of the subsidiary is the same as that of the parent, this profit will be arrived at after charging or crediting the exchange differences.

The non-controlling interest in total comprehensive income includes the NCI proportion of the exchange gain or loss on translation of the subsidiary financial statements.

It does not, however include any of the exchange gain or loss arising on the retranslation of goodwill.

Disclosure

• The amount of exchange differences recognised in profit or loss (excluding differences arising on financial instruments measured at fair value through profit or loss)
• Net exchange differences recognised in other comprehensive income and accumulated in a separate component of equity, and a reconciliation of the amount of such exchange differences at the beginning and end of the period
• When the presentation currency is different from the functional currency, disclose that fact together with the functional currency and the reason for using a different presentation currency
• A change in the functional currency of either the reporting entity or a significant foreign operation and the reason therefor

When an entity presents its financial statements in a currency that is different from its functional currency, it may describe those financial statements as complying with IFRS only if they comply with all the requirements of each applicable Standard (including IAS 21) and each applicable Interpretation.

Summary

Further Information