Financial liability in foreign currency to cost amortized (with transaction cost in functional currency)

[fr.perezca]

Hello everyone again,
I would like to present the following fictitious case: a company receives a loan in foreign currency (FCU) for FCU2000 on 1/1/x1 but the national regulation requires it to pay a tax on the amount received payable in functional currency (CU) of CU10,000. On 12/31/x1 an installment of FCU200 of the loan must be made and on 12/31/x2 an installment of FCU2,200 must be made. Spot exchange rates are as follows:
1/1/x1: CU100 for FCU1
12/31/x1: CU110. for FCU1, assuming that this is also average exchange rate to the year x1
12/31/x2: CU120 for FCU1, assuming that this is also average exchange rate to the year x2

What is the effective interest rate (EIR)?
What would be the financial expense to recognize in year x1 and x2?

When I thought about this situation, which is usual in my country, I went crazy.

I would greatly appreciate your help

[DJP]

Hello,

Any costs that are considered to be transaction costs are so because they are an integral part of the financial instrument's effective interest. As such -- and in my opinion -- any transaction costs in a currency other than the financial instrument's currency should be converted into the financial instruments's currency at the spot rate prevailing on the day the costs are incurred. You then determine your effective interest by looking at the instrument's cash flows and related transaction costs in the currency the instrument is denominated in. IAS 21 will then apply as usual to address foreign currency differences in the instrument's subsequent measurement. I don't think you will find anything in the standards that tell you how to deal with transaction costs in a currency other than the related instrument's, but this treatment is what makes sense to me.

[fr.perezca]

DJ Thank you. I thought about it before, the problem I find in translating the transaction costs to the currency of the financial instrument (the foreign currency) to build an amortization table in foreign currency and calculate the financial expense is that later when I translate to the functional currency the total financial expenses recognized throughout the life of the financial instrument will be greater than nominal interest + transaction costs, because part of the exchange difference recognized would be on an amount that was in the functional currency (transaction costs).

Loan amount: FCU 2000 (Fair value)
Transaction cost: FCU 100 (CU10000/100 of exchange rate)
initial measurement: FCU 1900

EIR calculated in Excel with IRR is 12,9973%

Amortization table in foreign currency:
year 1: initial balance: 1900; interest: 246,95; payment: 200; final balance: 1946.95
year 2: initial balance: 1946.95; interest: 253,05; payment: 2200; final balance: 0

FCU 246,95 x 110 exchange rate = CU 27164,5 and therefore it would be applying an increase due to the increase in the exchange rate to the part of the transaction cost as well (implicit in the financial expense).
FCU 253,05 x 120 exchange rate = CU 30366 and therefore it would be applying an increase due to the increase in the exchange rate to the part of the transaction cost as well (implicit in the financial expense).

It makes me noisy to consider the transaction costs as FCU 100 in the amortization table, that is, at all times of the life of the financial instrument, which are not (they were equivalent to it only at the beginning); As a result of this, I recognize, as I understand and explained before, a greater financial expense each year than the real one.
What do you think? Would this really be the procedure? Or how do I think there is a problem there? In that case, what do you suggest?
Thanks.

[DJP]

I don't really see a problem. Think of this from a net cash flow perspective. In the beginning you had a net cash inflow of FCU 1,900 which was equivalent to CU 190,000. And in the end you will have a cash outflow of FCU 2,000 which will be equivalent in CU to whatever rate is prevailing at that time. The easiest way to go about this is to determine the effective interest in foreign currency and then apply IAS 21 for the FX differences. Or... you come to the conclusion that straight line amortisation vs effective interest is not material, and you amortise the transaction cost separately in CU. This is not technically correct, but some companies do it so long not material.

[fr.perezca]

To make my question clearer (and what makes me noise), if I build an amortization table with fair value only (and omit transaction costs):

Amortization table in foreign currency:
year 1: initial balance: 2000; interest: 200; payment: 200; final balance: 2000
year 2: initial balance: 2000; interest: 200; payment: 2200; final balance: 0

the financial expense without the component of transaction costs:

FCU 200 x 110 exchange rate = CU 22000
FCU 200 x 120 exchange rate = CU 24000
the sum of financial expense that is recongnized is CU 46000 (notional) + CU 10000 of original transaction cost result in CU 56000
but the sum of financial exchange calculated in table that included transaction translated to exchange rate is CU 57530,5, for thur, is recognized CU1530,5 in excess as result of what I comment in my previous post

again, What do you think? Would this really be the procedure? Or how do I think there is a problem there? In that case, what do you suggest?
Thanks.

[fr.perezca]

DJP then you suggest doing it separately (that is, calculating financial expense or interest expense in the amortization table excluding transaction costs), and amortizing transaction costs on a linear basis? I like it, as you point out it should be immaterial. I would recognize at least actual expenses instead of an expense greater than actually incurred as mentioned (correct?)
Thanks

[DJP]

Yup. You can do it on materiality grounds. Just make sure you document the decision for future reference if needed.