IAS 21 The Effects of Changes in Foreign Exchange Rates

IAS 21 prescribes how to include foreign currency transactions and foreign operations in the financial statements of an entity and how to translate financial statements into a presentation currency.

IAS 21 is applied (IAS 21.3):

(a) in accounting for transactions and balances in foreign currencies, except for those derivative transactions and balances that are within the scope of IFRS 9;

(b) in translating the results and financial position of foreign operations that are included in the financial statements of the entity by consolidation or the equity method; and

(c) in translating an entity’s results and financial position into a presentation currency.

Statement of cash flows is excluded from the scope of IAS 21 as IAS 7 covers also presentation of cash flows arising from transactions in a foreign currency and the translation of cash flows of a foreign operation (IAS 21.7).

Functional currency is the currency of the primary economic environment in which the entity operates. The primary economic environment in which an entity operates is normally the one in which it primarily generates and spends cash. Paragraphs IAS 21.9-10 lists factors to consider in determining the functional currency of an entity.

Foreign currency is a currency other than the functional currency of the entity (IAS 21.8).

Determining functional currency may be particularly challenging when a reporting entity is a foreign operation of another entity and is in substance an extension of its operations. For example, a ‘financial’ subsidiary (i.e. a subsidiary that holds only financial assets or issues debt) with core financial assets/liabilities denominated in parent’s functional currency may have the same functional currency as the parent irrespective of the country that it operates in. Paragraph IAS 21.11 lists additional factors to consider when determining the functional currency of a foreign operation. When these indicators are mixed, priority is given to the primary indicators listed in paragraph IAS 21.9.

On initial recognition, foreign currency transaction is recorded at the spot exchange rate (i.e. rate for immediate delivery) between the functional currency and the foreign currency at the date of the transaction (IAS 21.21). A foreign currency transaction is a transaction that is denominated or requires settlement in a foreign currency, including transactions arising when an entity (IAS 21.20):

(a) buys or sells goods or services whose price is denominated in a foreign currency;

(b) borrows or lends funds when the amounts payable or receivable are denominated in a foreign currency; or

(c) otherwise acquires or disposes of assets, or incurs or settles liabilities, denominated in a foreign currency.

The date of the transaction is the date on which the transaction first qualifies for recognition in accordance with IFRS (IAS 21.22).

IAS 21 allows application of simplifications in determining the foreign exchange rate, e.g. by using an average rate, provided that exchange rates do not fluctuate significantly (IAS 21.22). In practice, entities most often use the average of monthly average rates, as these are usually published by central banks for most currencies.

At the end of each reporting period (IAS 21.23):

(a) foreign currency monetary items are translated using the closing rate;

(b) non-monetary items that are measured in terms of historical cost in a foreign currency are translated using the exchange rate at the date of the transaction;

(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 measured.

Specific procedures for translating foreign operations are discussed below.

Monetary items are defined as units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency (IAS 21.8). Most common examples of monetary items include trade receivables and payables or loans. Other examples are given in paragraph IAS 21.16.

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 of non-monetary items include advance consideration paid or received, goodwill, PP&E, intangible assets, inventories and provisions that are to be settled by the delivery of a non-monetary asset (see IAS 21.16). Investments in equity instruments are also non-monetary items (IFRS 9.B5.7.3).

As a rule, exchange differences arising on settlement on translation of a monetary asset are recognised in P/L (IAS 21.28).

When non-monetary assets are measured at fair value (or revalued amount) in a foreign currency, exchange differences are recognised the same way as gains/losses on remeasurement, i.e. they can be recognised in other comprehensive income in instances specified by other IFRS (IAS 21.30-31).

Example: recognition of exchange differences

Entity A purchases an item of PP&E on 1 January 20X1. Entity A’s functional and presentation currency is EUR, the invoice for the PP&E is for USD 1,000. EUR/USD rate on 1 January 20X1 is 1.1 (i.e. 1 EUR = 1.1 USD). The invoice is paid on 1 May 20X1 when the EUR/USD rate is 1.2. Entries made by Entity A in EUR are as follows (you can download an excel file for this example):

1 January 20X1DRCR
PP&E909
Payables909
1 May 20X1DRCR
PP&E--
Cash833
Payables909
Exchange differences (P/L)76

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As we can see, an item of PP&E is carried at historical cost and is not subsequently retranslated to reflect movements in exchange rates between initial recognition and invoice payment.


IFRIC Interpretation 22 ‘Foreign Currency Transactions and Advance Consideration’ clarifies that the date of the transaction for the purpose of determining the exchange rate to use on initial recognition of the related asset, expense or income is the date on which an entity initially recognises the non-monetary asset or non-monetary liability arising from the payment or receipt of advance consideration (IFRIC 22.8-9).

Paragraph IAS 23.6(e) states that borrowing costs may include exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs.

Exchange differences on deferred foreign tax liabilities or assets can be classified as deferred tax expense (income) in P/L (or OCI in certain instances specified in IFRS) (IAS 12.78).

Functional currency can be changed only if there is a change to underlying transactions, events and conditions that the functional currency reflects. Change in functional currency is accounted for prospectively (IAS 21.35-37).

A group entity with a presentation currency different from the presentation currency of the consolidated financial statements is translated using the following procedures (IAS 21.39):

(a) assets (including goodwill and fair value adjustments – IAS 21.47) and liabilities are translated at the closing rate at the reporting date (including comparatives translated using historical rates);

(b) income and expenses are translated at exchange rates at the dates of the transactions (including comparatives translated using historical rates); and

(c) all resulting exchange differences are recognised in other comprehensive income.

IAS 21 allows application of simplifications in determining the foreign exchange rate, e.g. by using an average rate, provided that exchange rates do not fluctuate significantly (IAS 21.40). In practice, an average rate for each month is used most often.

The exchange differences referred to in IAS 21.39(c) are often referred to as currency translation adjustment or CTA. Their two major sources are (IAS 21.41):

(a) translating income and expenses at the exchange rates at the dates of the transactions and assets and liabilities at the closing rate.

(b) translating the opening assets and liabilities at a closing rate that differs from the previous closing rate.

CTA are recognised in OCI, presented as a separate item within equity and not recycled to P/L until the disposal of the foreign operation. Furthermore, they are split between controlling and non-controlling interest (IAS 21.41).

Example: basic translation of a foreign operation

Group A has EUR as its presentation currency. Entity X is one of subsidiaries of Group A with USD as its presentation currency. The following exchange rates apply:

EUR/USD rate at 1 January 20X1: 1.1
EUR/USD average rate in 20X1: 1.2
EUR/USD rate at 31 December 20X1: 1.3

All calculations and tables presented in this example can be downloaded as an excel file.

Entity X is consolidated to Group A financial statements as follows:

Entity X stand-alone data

Statement of financial position (USD)

1 Jan 20X131 Dec 20X1
Assets5,0005,300
Share capital2,0002,000
Retained earnings-300
Total equity2,0002,300
Liabilities3,0003,000

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P/L for year 20X1 (USD)

Revenue1,000
Expenses(700)
Net income300

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Consolidation of Group A

Consolidated statement of financial position (EUR) – 1 January 20X1

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Stand-aloneStand-aloneConsolidationConsolidated
Parent (A)Subsid (X)adjustmentsGroup (A+X)
Investment in X1,818-(1,818)-
Other assets7,0004,545-11,545
Total assets8,8184,545(1,818)11,545
Share capital3,0001,818(1,818)3,000
Retained earnings----
Total equity3,0001,818(1,818)3,000
Liabilities5,8182,727-8,545

Consolidated statement of financial position (EUR) – 31 December 20X1

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Stand-aloneStand-aloneConsolidationConsolidated
Parent (A)Subsid (X)adjustmentsGroup (A+X)
Investment in X1,818-(1,818)-
Other assets8,0004,07712,077
Total assets9,8184,077(1,818)12,077
Share capital3,0001,538(1,538)3,000
Retained earnings1,000231191,250
CTA--(299)(299)
Total equity4,0001,769(1,818)3,951
Liabilities5,8182,308-8,126

Consolidated P/L for year 20X1 (EUR)

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Stand-aloneConsolidationConsolidated
Parent (A)Subsid (X)adjustmentsGroup (A+X)
Revenue2,500833-3,333
Expenses(1,500)(583)-(2,083)
Net income1,000250-1,250
CTA (OCI)-(299)(299)


Intragroup balances are obviously eliminated on consolidation, however exchange differences arising of those balances are not eliminated, as the group is effectively exposed to foreign exchange gains/losses even on intragroup balances (IAS 21.45). This includes also dividend receivables and payables.

As stated before, goodwill is treated as an asset of a foreign operation and is re-translated at each reporting date. For acquisitions of multinational groups, goodwill should be allocated to the level of each functional currency of the acquired foreign operation (IAS 21.BC32).

Net investment in a foreign operation is the amount of the reporting entity’s interest in the net assets of that operation (IAS 21.8). Monetary items receivable from or payable to a foreign operation for which settlement is neither planned nor likely to occur in the foreseeable future are treated as a part of the entity’s net investment in that foreign operation (IAS 21.15-15A).

Exchange differences arising on a monetary item that forms part of a reporting entity’s net investment in a foreign operation are recognised in P/L in separate financial statements, but are recognised in OCI (as a part of CTA) in consolidated financial statements (IAS 21.32-33).

The above rules applicable to translating a foreign operation are also applicable to use of a presentation currency other than the functional currency in general.

On the disposal of a foreign operation, the cumulative amount of the exchange differences relating to that foreign operation, recognised in other comprehensive income and accumulated in the separate component of equity (i.e. CTA), are reclassified from equity to P/L (as a reclassification adjustment) when the gain or loss on disposal is recognised (IAS 21.48).

Additionally, paragraph IAS 21.48A specifies accounting for partial disposals.

Separate provisions on translating from the currency of a hyperinflationary economy are given in paragraphs IAS 21.42-43.

IAS 21 is silent on which part of P/L should foreign exchange differences be presented in. Entities need therefore to develop an accounting policy. The most usual approach is that exchange differences are presented in different areas of P/L depending on item which they arose on. For example, exchange differences on trade receivables are presented within operating profit and exchange differences on debt are presented within finance costs.

Disclosure requirements are set out in paragraphs IAS 21.51-57.

 


© 2018-2019 Marek Muc

Excerpts from IFRS Standards come from the Official Journal of the European Union (© European Union, https://eur-lex.europa.eu). The information provided on this website does not constitute professional advice and should not be used as a substitute for consultation with a certified accountant.