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IAS 21 – The effects of changes in foreign

currency exchange rates

Introduction:

World has become smaller with time. This phrase was correctly identified sensing

that the globe becomes a local place to trade. Today’s world sees cross border

transactions, foreign funding, inflows, outflows, exports and imports.

Requirements of one country are usually fulfilled by another country in terms of

resources available with the latter. This assumes importance of foreign currency

and exchange rates between local and foreign currencies.

This accounting standard mentions about the treatment of foreign currency and

treatment of balances lying in financial statements in foreign currency.

Learning Outcomes:

- Discuss the recording of transactions and translation of monetary/non-

monetary items at the reporting date for individual entities in accordance with

relevant accounting standards;

- Distinguish between reporting and functional currencies

- Determine an entity’s functional currency

-

Determine an entity’s functional currency – (Learning Outcome 1)

Concept of functional currency

Functional currency is the currency of the primary economic environment in

which the entity operates.

Foreign currency is a currency other than functional currency.

The primary economic environment in which an entity operates is normally the

one in which it primarily generates and expends cash. An entity considers the

following factors in determining its functional currency:

(a) the currency:

(i) that mainly influences sales prices for goods and services (this will often be the

currency in which sales prices for its goods and services are denominated and

settled); and

(ii) of the country whose competitive forces and regulations mainly determine the

sales prices of its goods and services.

K Inc, a US company, sells goods in India through its branch office in India. The

selling price of goods in Indian market is determined by local market factors,

competitors’ prices, etc. The currency which impacts the pricing for goods to be

sold by K Inc is INR in the above case.

(b) the currency that mainly influences labour, material and other costs of

providing goods or services (this will often be the currency in which such costs

are denominated and settled).

Example:

K Inc, a US company, has set up its branch office in India. The procurement

(purchases) is done from local markets in INR. The cost of set up is in INR, and

other expenses are all incurred in local currency. There are a few notional

expenses payable to the US parent, which are paid in USD.

In the above case, the functional currency would be INR, although a small

proportion of expenses are paid in USD.

The following factors may also provide evidence of an entity’s functional

currency:

(a) the currency in which funds from financing activities (ie issuing debt and

equity instruments) are generated.

(b) the currency in which receipts from operating activities are usually retained.

The following additional factors are considered in determining the functional

currency of a foreign operation, and whether its functional currency is the same as

that of the reporting entity (the reporting entity, in this context, being the entity

that has the foreign operation as its subsidiary, branch, associate or joint venture):

Foreign operation is an entity that is a subsidiary, associate, joint venture or

branch of a reporting entity, the activities of which are based or conducted in a

country or currency other than those of the reporting entity.

(a) 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. An example of the former is when the foreign operation only sells

goods imported from the reporting entity and remits the proceeds to it.

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Example:

K Ltd, is the Indian representative office of K Inc. All the goods come from K Inc

(software licences which K Inc deals into), and are sold to distributors through K

Ltd (Indian representative office). The funding of K Ltd was done by K Inc (by

investing $100,000). The purchase of software licenses are made in USD, the

collections by sale of these licenses are sent in USD. However, due to local

regulatory requirements, the billing is done in INR. The invoice, however, bears

spot rate of USD / INR on the date of sale (for example 1 unit sold for $500

= INR 25,000).

There are no local purchases of equipments made by K Ltd.

In the above example, K Ltd’s functional currency is determined as USD and not

INR. Though the economy in which it operates is India with local currency INR),

the fact remains that significant dealing is happening in USD. Hence, the

functional currency is determined as USD, and not INR.

(b) whether transactions with the reporting entity are a high or a low proportion of

the foreign operation’s activities.

Example

K Ltd (an Indian company), sells all its goods to K Inc (its US parent company).

Though the purchases are made locally, the eventual sales are all done to the US

company. It may be said that the functional currency of K Ltd is USD and not

INR.

(c) 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.

Example

K Inc, a US company, has a subsidiary in China. The Chinese subsidiary receives

funds from K Inc, manufacturers goods on behalf of K Inc and sends these goods

back to K Inc for sales in US market and other countries. The Chinese subsidiary

also makes local sales, but would remit the funds back to the US parent as and

when these arise.

In the above case, the cash flows of the foreign operations (Chinese subsidiary),

are all meant to be used by the US entity. Hence, it may be identified that the

functional currency of the Chinese subsidiary is USD and not Chinese Yuan.

(d) 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.

When the above indicators are mixed and the functional currency is not obvious,

management uses its judgement to determine the functional currency that most

faithfully represents the economic effects of the underlying transactions, events

and conditions.

Example

K Ltd, an Indian company, is a subsidiary of K Inc, a US company. It receives

funds from K Inc, establishes an office in India and manufactures goods. These

goods are sold both to K Inc and also in local market. The expenses of salaries,

rent, purchases etc are all paid in INR. However, the surplus funds (after

providing for expenses) are remitted back to K Inc in the US.

In the above case, it may be difficult to ascertain as to which currency may be

ascertained as functional currency, the decision is left to the management.

* Usually, the functional currency in above case is the local currency in which

the expenses are incurred.

An entity’s functional currency reflects the underlying transactions, events and

conditions that are relevant to it. Accordingly, once determined, the functional

currency is not changed unless there is a change in those underlying transactions,

events and conditions

Discuss the recording of transactions and translation of monetary /

non-monetary items at the reporting date for individual entities in

accordance with relevant accounting standards

– Learning Outcome 2

We understood the meaning of foreign currency as a currency other than the

functional currency. Accordingly, a foreign currency transaction is a transaction

that is denominated in a foreign currency; or requires settlement in a foreign

currency.

Example:

Loan taken in foreign currency;

Sale / purchases made in foreign currency;

Assets bought / sold in foreign currency.

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The accounting for above transactions will be done in functional currency in the

books of account. However, these transactions are all foreign currency

transactions and would require the settlement also in foreign currency only.

The standard requires an initial measurement (at the time transaction took place)

and subsequent measurement (at reporting date) on the basis of whether the item

is a monetary or non-monetary item.

Monetary items

The essential feature of a monetary item is a right to receive (or an obligation to

deliver) a fixed or determinable number of units of currency. Examples include:

- pensions and other employee benefits to be paid in cash;

- receivables;

- loans and advances given;

- loans received;

- provisions that are to be settled in cash;

- cash dividends that are recognised as a liability.

Non-monetary items

The essential feature of a non-monetary item is the absence of a right to receive

(or an obligation to deliver) a fixed or determinable number of units of

currency. Examples include:

- amounts prepaid for goods and services (eg prepaid rent);

- goodwill;

- intangible assets;

- inventories;

- property, plant and equipment; and

- provisions that are to be settled by the delivery of a non-monetary asset.

Initial measurement / recognition

A foreign currency transaction shall be recorded, on initial recognition in the

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.

At the end of each reporting period:

(a) Foreign currency monetary items shall be translated using the closing rate;

Example

K Ltd, an Indian company, took a loan of USD 10,000 from K Inc (a US

company) on 1st January 2011. The spot rate of USD/INR on 1

st January 2011 is

50.00-49.75. On 31st March 2011 (reporting date), the spot rate (USD/INR) is

49.70/49.45.

In the above example, K Ltd shall value the loan at INR 500,000. On the reporting

date, the value of the loan is INR 497,000. The difference should be taken to the

SOCI as realised exchange gain / loss account. (in this case, it is a notional gain of

INR 3,000).

Example

K Inc, a US company, sold goods worth USD 10,000 to K Plc (a UK company)

on 1st January 2011. The spot rate of GBP/USD on 1

st January 2011 is 1.60-1.58.

On 31st March 2011 (reporting date), the spot rate (GBP/USD) is 1.55/1.52.

In the above example, K Plc shall value the payables of USD 10,000 at GBP

6,329. On the reporting date, the value of the payables is GBP 6,579. The

difference should be taken to the SOCI as realised exchange gain / loss account.

(in this case, it is a notional loss of GBP 250).

(b) Non-monetary items that are measured in terms of historical cost in a

foreign currency shall be translated using the exchange rate at the date of the

transaction; and

Example

K Ltd, an Indian company, bought a machine of USD 10,000 from K Inc (a US

company) on 1st January 2011. The spot rate of USD/INR on 1

st January 2011 is

50.00-49.75. On 31st March 2011 (reporting date), the spot rate (USD/INR) is

49.70/49.45.

In the above example, K Ltd shall value the machine at INR 500,000. On the

reporting date, the value of the machine would still remain as INR 500,000

(historical rate)

(c) Non-monetary items that are measured at fair value in a foreign currency

shall be translated using the exchange rates at the date when the fair value was

determined.

In case the carrying value of the non-monetary item is arrived at through a

formula (lower of cost or Net Realisable Value), the components (cost and net

realisable value) are separately calculated.

Example:

K Ltd, an Indian company, buys goods from US. On 1st January 2011, it bought

goods of USD 10,000. On the reporting date (31st March 2011), 10% of the goods

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are still remaining in the warehouse of K Ltd. The net realisable value of these

goods is USD 950.

The spot rates on 1st January 2011 and 31

st March 2011are USD/INR = 50.00 and

USD/INR = 51.70 respectively.

In the above case, the value of inventory recorded in the books is INR 500,000.

On the reporting date, the inventory worth USD 1,000 is now valued at USD 950

(net realisable value).

Value of inventory in functional currency at cost is = 1,000 x 50 = 50,000

Value of inventory in functional currency at net realisable value is 950 x 51.70 =

49,115.

The inventory is reported in the books at 49,115, and not at 50,000.

When a gain or loss on a non-monetary item is recognised in other comprehensive

income, any exchange component of that gain or loss shall be recognised in other

comprehensive income.

Example

K International, a British company, buys a piece of land in Germany for EUR

80,000 (spot rate 1EUR = 0.67 GBP). It was revalued during the year at EUR

82,000 (spot rate 1EUR = 0.70 GBP). K International sold the piece of land

before the year-end for EUR 90,000 (spot rate 1EUR = GBP 0.60).

In the above case, the revaluation gain/loss should be calculated as per the

exchange rate as on the revaluation date.

The revaluation gain/loss is:

Cost of land

= EUR 80,000 x 0.67

=GBP 53,600

Revaluation amount

= EUR 82.000 x 0.70

= GBP 57,400

Total gain in OCI

= GBP 3,800

At the time of sale:

Carrying amount in books

= GBP 57,400.

Sale value

= EUR 90,000 x 0.60

= GBP 54,000.

Loss on sale of GBP 3,400 is recognised in income statement. Also, the

revaluation gain of GBP 3,800 is transferred to retained earnings.

Change in functional currency

When there is a change in an entity’s functional currency, the entity shall apply

the translation procedures applicable to the new functional currency prospectively

from the date of the change.

Translation to the presentation currency

An entity may present its financial statements in any currency (or currencies). If

the presentation currency differs from the entity’s functional currency, it

translates its results and financial position into the presentation currency. For

example, when a group contains individual entities with different functional

currencies, the results and financial position of each entity are expressed in a

common currency so that consolidated financial statements may be presented.

The results and financial position of such entity are arrived at using the following

procedures:

(a) Assets and liabilities for each statement of financial position presented (ie

including comparatives) shall be translated at the closing rate at the date of that

statement of financial position;

(b) Income and expenses for each statement of comprehensive income or separate

income statement presented (ie including comparatives) shall be translated at

exchange rates at the dates of the transactions; and

(c) All resulting exchange differences shall be recognised in other comprehensive

income (equity – retained earnings).