E-14 Advanced Accounting and Financial Reporting Lecture 11 & 12 IAS 21 Effect of Changes in Foreign Exchange Rates Foreign Subsidiary Consolidation Practice

E-14 Advanced Accounting and Financial Reporting

Lecture 11 & 12IAS 21 Effect of Changes in Foreign Exchange RatesForeign Subsidiary ConsolidationPractice and Revision

Sajid Shafiq, ACA

IAS 21, Consolidation of Foreign Subsidiary Practice Qs

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IAS 21-Overview• Objectives, Scope and Definitions• Functional Currency• Presentation Currency• Monetary and Non-monetary items• Transactions in Foreign Currency

– Initial recognition– Reporting at subsequent reporting dates– Recognition of exchange difference

• Transactions settled within the period• Transaction balance outstanding at end of reporting period

– Net investment in a Foreign Operation– Change in Functional Currency

• Translation into Presentation Currency (Foreign Subsidiary Consolidation)– Procedures for translation into Presentation Currency– Hyperinflationary Economies– Goodwill– Disposal of a Foreign Operation

Objectives, scope and Definitions

IAS 21, Consolidation of Foreign Subsidiary Practice Qs 3

Objectives• To prescribe how to include

foreign currency transactions and foreign operations in the FS of an entity, and how to translate FS into a different currency for presentation purposes.

ScopeIAS 21 applies to:• accounting for foreign currency transactions;• translating the FS of foreign operations that are included in the FS of

another entity, for example, on consolidation of subsidiaries or the inclusion of associates by the equity accounting method; and• translating an entity's results and financial position into a different

currency for the presentation of its FS.

DefinitionsClosing rate is the spot exchange rate at the end of the reporting period.Exchange difference is the difference resulting from translating a given number of units of one currency into another currency at different exchange rates.Exchange rate is the ratio of exchange for two currencies.Foreign currency(FCY) is a currency other than the functional currency of the entity.Foreign operation(FO) is an entity that is a subsidiary, associate, JV 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.Functional currency is the currency of the primary economic environment in which the entity operates.Monetary items are units of currency held and assets and liabilities to be receivedor paid in a fixed or determinable number of units of currency. Net investment in a foreign operation is the amount of the reporting entity’s interest in the net assets of that operation.Presentation currency (PC)is the currency in which the FS are presented.


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Functional CurrencyAn Entity

•An entity cannot choose its functional currency; instead, management needs to make an informed assessment of the facts. Indicators to consider include (in order of priority)•the currency that mainly influences the prices at which goods and services are sold;•the country whose competitive forces and regulations mainly influence the pricing structure for the supply of goods and services;•the currency in which financing is generated; and•the currency in which cash generated from an entity’s operating activities is usually retained.

A Group•In a group, each entity, for example the parent, each subsidiary and associate, needs to determine its own functional currency rather than adopting a single one which is common across the whole group.•Additional factors should be considered to determine whether the functional currency of a FO is the same as that of the reporting entity (the group). The overriding factor is whether the FO operates independently of the reporting entity or is merely an extension of that entity.

For a group of entities, IAS 21 requires a two stage process:1. Individual entity level: treatment of foreign exchange transactions

(functional currency); and2. Consolidation level: translation of the FS of entities, for example

subsidiaries, associates and branches, into a common currency for consolidated FS purposes (presentation currency).

Additional factors for FO•Whether the activities of the FO are carried out as an extension of the reporting entity, or are being carried out with a significant degree of autonomy. An example of the former is when the FO only sells goods imported from the reporting entity and remits the proceeds to it. An example of the latter is when the operation accumulates cash and other monetary items, incurs expenses, generates income and arranges borrowings, all substantially in its local currency.•Whether transactions with the reporting entity are a high or a low proportion of the FO’s activities.•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.•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.


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Effect of Selection of Functional Currency

On 01 January 2011, A Co operating in US purchases inventory from an EU country on credit of one month. The value of inventory in € is 100,000. The details of exchange rates is as follows:01- Jan $/€ = 1.531- Jan $/€ = 2.0

The effect of selection of $ or € as functional currency will be:

Date $ as Functional Currency € as Functional Currency

01- Jan Dr. Inventory $150,000 Cr. Payable $150,000

Dr. Inventory €100,000 Cr. Payable €100,000

31-Jan Dr. Payable $150,000Dr. Exchange Loss (ß) $ 50,000 Cr. Bank $200,000

Dr. Payable €100,000 Cr. Bank €100,000


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Presentation Currency

• IAS 21 does not require to present financial statements using functional currency. An entity has a completely free choice of the currency in which its financial statements are presented.

• The approach that is required to translate the financial statements of an entity, or a group of entities, into a different presentation currency is discussed later.


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Monetary and Non-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; – provisions that are to be settled in cash; and – cash dividends that are recognised as a liability.

• Conversely, 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.


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Transactions in the Functional CurrencyInitial recognition

• An entity should record FCY , for example the buying or selling of goods or services whose price is denominated in a FCY, in a consistent manner.

• An entity does this by recognising each transaction at the spot exchange rate on the date that the transaction took place. • Thus, if an entity whose functional currency is CU buys a non-current asset for N$1 million when the spot exchange rate

is CU1:N$2, then the transaction will initially be recorded at CU500,000.• Where there are high volumes of such transactions, for practical reasons an average exchange rate over the relevant

period may be used as an approximation. However, if exchange rates fluctuate significantly over short periods of time it is not appropriate to use an average rate since it would not be a fair approximation for actual rates.

Reporting at the ends of subsequent reporting periodsAt the end of each reporting period the following translations of foreign currency should be carried out.

Item Exchange rate

Monetary items Closing rate (i.e. the spot exchange rate at the end of the reporting period)

Non-monetary items measured at historical Cost Rate of exchange at the date of the original transaction (i.e. the date of purchase of the non-current asset)

Non-monetary items measured at fair value Exchange rate at the date when fair value was determined


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Recognition of exchange differences• The difference that arises from translating the same amounts at different exchange rates is

referred to as an exchange difference. • Such amounts will generally arise in the preparation of a set of FS from the settlement of

monetary amounts payable or receivable in a foreign currency and the retranslation at the entity’s period end.

• Exchange differences should normally be recognised as part of the profit or loss for the period. • However, where gains and losses on a non-monetary item are recognised in OCI, for example a

gain on the revaluation of a property in accordance with IAS 16, any exchange difference resulting from retranslation of the revalued asset is also reported as part of OCI.

Transactions settled within the periodWhen a FCY is settled within the same accounting period as that in which it was originally recorded, any exchange differences arising are recognised in the profit or loss of that period.

Transaction balance is outstanding at the end of the reporting periodWhen a FCY is settled in a different accounting period to the one in which the transaction originated, the exchange difference recognised in profit or loss for each period, up to the date of settlement, is determined by the change in exchange rates during each period.


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Recognition of Exchange Differences

IllustrationWarrilow has a year end of 31 December 2007 and uses the CU as its functional currency.

On 29 November 2007, Warrilow received a loan from a foreign bank for N$1,520,000. The proceeds were used to finance, in part, the purchase of a new office block. The loan remained unsettled at the year end.Exchange rates:29 November 2007 CU1 = N$1.5231 December 2007 CU1 = N$1.66

The following amounts should be recorded by Warrilow, ignoring interest payable on the loan.29 November 2007The cash advance from the bank is translated at the rate on the date that it was received (N$1,520,000 / 1.52 = CU1,000,000) and a liability recorded for the same amount.

31 December 2007As the loan was still outstanding at the end of the period and it is a monetary item, it should be retranslated at the exchange rate at the end of the reporting period (N$1,520,000 / 1.66 = CU915,663 ). The exchange difference should be recognised as a gain in profit or loss for the period. (CU1,000,000 less CU915,663 = CU84,337).

Recognition of Exchange DifferencesIllustrationAston has a year end of 31 Dec 2007 and uses the CU as its functional currency. On 25 Oct 2007 Aston buys goods from an overseas supplier for N$286,000. The goods are still held by Aston as part of inventory at the year end.Exchange rates:25 October 2007 CU1 = N$11.16 16 November 2007 CU1 = N$10.87 31 December 2007 CU1 = N$11.25

(a) If, on 16 November 2007, Aston pays the overseas supplier in full the following entries should be recognised:25 October 2007.The initial transaction is recorded as a purchase and a liability at the exchange rate at the date that the transaction took place (N$286,000 / 11.16 = CU25,627).16 November 2007.The actual cost of settling the liability on the date of settlement is calculated (N$286,000 / 10.87 = CU26,311). The exchange difference between the originally recorded liability and the actual amount required to settle it (CU25,627 less CU26,311 = CU684) is recorded as an exchange loss in profit or loss for the period. Inventories at the year end are nonmonetary items and will be carried at their original value i.e. CU25,627.

(b) If the supplier had remained unpaid at the year-end, the following transactions would have been recognised:25 October 2007.The initial transaction is recorded as above at CU25,627.31 December 2007.The year-end balance is retranslated at the year-end exchange rate as it is a monetary liability. (N$286,000 / 11.25 = CU25,422) The difference should be reported as part of the profit or loss for the period. The exchange gain recognised in profit or loss will be CU205 (CU25,627 less CU25,422 = CU205). The value of inventories at the year end will be CU25,627 (as recorded above).



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Net Investment in a Foreign Operation• An entity may have a monetary amount receivable from, or payable to, a foreign entity (for

example an overseas subsidiary) that is not intended to be settled in the foreseeable future. • For a receivable, this amount essentially forms part of the overall investment in the foreign

entity. At the period-end, monetary amounts such as this are retranslated and any differences recognised in profit or loss of the appropriate entity. But IAS 21 operates on the basis that as such differences are part of the overall investment in the foreign entity, they should only be recognised in profit or loss when the foreign entity is disposed of.

• In the preparation of the consolidated FS, any exchange difference arising from the net investment in a foreign operation should be reported initially in OCI and not in the consolidated profit or loss for the period. If the foreign entity is subsequently sold, any such exchange differences will form part of the reported profit or loss on disposal by reclassifying the amount from equity to profit or loss.

• The loan could be made by a group entity other than the parent entity. For example, an entity has two subsidiaries, A and B. Subsidiary B is a foreign operation. Subsidiary A grants a loan to Subsidiary B. Subsidiary A’s loan receivable from Subsidiary B would be part of the entity’s net investment in Subsidiary B if settlement of the loan is neither planned nor likely to occur in the foreseeable future. This would also be true if Subsidiary A were itself a foreign operation.

• It is only differences relating to the overall investment in the foreign entity which are recognised in other comprehensive income; differences on intra-group trading balances which will be settled in the short term remain in the profit or loss of the period.


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Change in Functional Currency

• If the underlying economic activities change in such a way that there is a change in the functional currency of an entity, the new functional currency should be applied prospectively from the date of the change in circumstances.

• The entity should not restate amounts previously recorded as these reflected the economic reality at that time.

• All amounts should be retranslated into the new functional currency at the date of the change.


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Translation into Presentation CurrencyProcedures for translation into presentation currency

•The translation into a PC can be undertaken by an individual entity, if it decides to present its FS in a currency different to its functional currency.•Much more commonly, it is undertaken when entities within a group have functional currencies different from the PC of the parent. For the preparation of the group’s CFS, such entities will need to retranslate their FS into the PC being used.•The steps to translate financial statements into a different presentation currency are:

•retranslate the assets and liabilities for each SFP presented (i.e. the current period end and the comparative period) at the closing rate at the date of that statement of financial position;•retranslate income and expenditure recorded in each SCI presented (i.e. the current period and the comparative period) at the exchange rates at the dates of the transactions; for practical reasons an average rate may be used for each period, assuming that the exchange rate does not fluctuate significantly during the period; and•recognise all resulting exchange differences in other comprehensive income.

•Where exchange differences relate to a FO that is not wholly owned, accumulated exchange differences attributable to the NCI should be allocated to NCI in the consolidated SFP.

Hyperinflationary economies•Where an entity has a functional currency that is the currency of a hyperinflationary economy, it is required to restate its functional currency FS in accordance with IAS 29•If, however, such an entity chooses to use a different PC, the requirements in IAS 21 for the retranslation of the FS into the PC should be applied


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Goodwill• In the CFS, any goodwill arising on the acquisition of a FO should be treated as an

asset of the FO. • The GW should therefore be expressed in the functional currency of the FO and

translated at the closing rate at the date of each SFP. • The same treatment is required of any fair value adjustments to the carrying

amounts of assets and liabilities arising on the acquisition of a FO. • In both cases exchange differences are recognised in OCI, rather than as part of the

profit or loss for the period.Illustration • An entity acquires a foreign subsidiary on 15 August 2007. The goodwill arising on

the acquisition is R$400,000. At the date of acquisition the exchange rate into the parent’s functional currency is R$4:CU1. At the parent entity’s year end the exchange rate is R$5:CU1.

• The goodwill at the date of acquisition is CU100,000 (R$400,000/4). At the year end it is retranslated to CU80,000 (R$400,000/5). The difference of CU20,000 is recorded as an exchange loss and reported in other comprehensive income.


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Disposal of a foreign operation

• Where a foreign entity is disposed of, any exchange differences that have been recognised in OCI and accumulated in a separate component of equity are required to form part of the profit or loss on disposal.

• Such amounts will therefore be reclassified from equity to profit or loss as a reclassification adjustment in the period in which the disposal takes place.


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Disposal of foreign operation


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Dis

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Practice Question- Foreign Operation



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Class Practice Question


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Practice and Revision QuestionsGroup Accounts area Paper Attempt

Foreign Subsidiary E-14 Dec-10

Piecemeal Acquisition and Disposal E-14P-2

Dec-09, Dec-06Dec-09

Jointly Controlled Entity E-14 Jun-10, Jun-06

Consolidated Statement of Cash Flow E-14P-2

Dec-10Dec-10

Consolidated SFP(including associate) F-7 Jun-10

Consolidated SCI(including associate) F-7 Dec-09

Combined Question on CSFP and CSCI F-7 Dec-10

Complex Group, CSCI P-2 Jun-10

Complex Group, CSFP P-2 Dec-07

Documents

E-14 Advanced Accounting and Financial Reporting Lecture 11 & 12 IAS 21 Effect of Changes in Foreign Exchange Rates Foreign Subsidiary Consolidation Practice