IAS 21 – The Effects of Changes in Foreign Exchange Rates
Why do changes in foreign exchange rates create accounting challenges?
Most entities in the modern business world conduct activities or transactions in more than one currency. A reporting entity’s activity may be conducted in a foreign currency in two ways: first, the reporting entity may enter directly into transactions denominated in foreign currency, the results of which must be translated into the currency in which the reporting entity measures its performance and financial position. Second, the reporting entity may hold foreign operations through a foreign entity (such as a subsidiary, an associate, or a joint arrangement), which measures its activity in a foreign currency. In such a case, the financial statements of the foreign entity must be translated for inclusion in the financial statements of the reporting entity.
Moreover, in today’s modern business world, which includes global markets and worldwide operations, there may be cases where companies are incorporated or registered in one country but conduct and manage their business mainly in a currency (the functional currency) that is not the local currency of that country. In addition, results and financial position may sometimes be reported in a third currency (which is neither the local nor the functional currency). Such cases may arise from economic motives, such as export markets, raising capital, or hiring human resources, as well as from taxation and/or purely legal considerations. For example, many companies in the technology sector may be incorporated in one country where a certain currency is used, conduct their ongoing operations using the currency of another country, and be traded in a third country where yet another currency is used.
In addition, there are many countries, particularly in Eastern Europe and Africa, where the currency in which transactions are denominated and/or indexed (not necessarily in a specific line of business) may differ from the local currency. Accordingly, reporting entities operating in such countries must take this factor into account when determining their functional currency.
Which two main areas must the accounting treatment address?
The accounting treatment must therefore address challenges in two main areas:
- Determination of the functional currency
Determining the functional currency can have a significant impact on financial reporting in general and on the measurement of results in particular, and consequently on the decisions of users of the financial statements. For example, a company that takes out a dollar loan will report the effects of the exposure to changes in the U.S. dollar exchange rate if its functional currency is the Euro but will not report such exposure if its functional currency is the U.S. dollar.
In order to ensure that the information in the financial statements is useful to different users in accordance with the objectives of financial reporting, the measurement currency must be the currency that reflects the economic substance of the activity (the functional currency), and not necessarily the local currency of the country in which the activity is conducted or registered (substance over form). For example, in the case of the dollar loan above, the question is whether, economically, the company is exposed to fluctuations in the U.S. dollar exchange rate, regardless of the geographic or legal location of the company’s activity. If the answer is yes, then the functional currency of the company is likely to be the U.S. dollar, even if the company is registered and operates in another country.
The term “foreign currency,” therefore, is relative to the functional currency. For example, an activity conducted in the local currency may be considered a foreign currency activity, while activity conducted in a currency other than the local currency may be considered activity in the functional currency. However, only one measurement currency must be determined for each entity, even if its activities are conducted in multiple currencies. As a result, the next challenge faced by accounting standards is how an entity should translate transactions conducted in a foreign currency (i.e., in a currency other than the functional currency) into the functional currency.
2. Translation into the functional currency of foreign currency transactions and translation of financial statements of a foreign operation.
What is the difference between translating foreign currency transactions and foreign operations?
There is a significant difference between translating transactions conducted by a reporting entity in a currency other than its functional currency (foreign currency) and translating the financial statements of entities whose functional currency is different for consolidation purposes or for using the equity method.
For illustration, consider a case where a UK company (functional currency: pound) takes out a dollar loan, compared to a case where a subsidiary operating in the U.S. (functional currency: U.S. dollar) takes out a dollar loan. Although in both cases the loan must be translated at the current exchange rate in order to reflect the expected repayment in pounds, in the first case the activity is economically exposed to exchange rate fluctuations and consequently finance income or expenses reflecting exchange rate changes will be recognised in profit or loss, while in the second case the activity is not exposed to such fluctuations at all. This can also be seen in cash flow terms: an entity required to repay the loan in pounds will pay a higher amount of cash (assuming the dollar strengthens against the pound), whereas the cash flows of the dollar-based activity will not change, as they are measured in dollar terms, and therefore exchange rate changes are irrelevant to it.
Accordingly, IFRS Accounting Standards make a distinction between the translation into the functional currency of transactions conducted by a reporting entity in a currency other than its functional currency (foreign currency), and the translation of the financial statements of a separate entity whose functional currency differs from that of the reporting entity.
How are exchange differences recognised?
In the case of foreign currency transactions, there is a distinction between monetary items, which are measured at the current exchange rate and create exposure to foreign currency exchange rates in profit or loss, and non-monetary items, which are measured at the historical exchange rate and therefore do not create foreign currency exposure, since changes in exchange rates do not directly affect cash flows.
On the other hand, in the case of translation of financial statements of a foreign operation, all assets and liabilities are measured at the current exchange rate, income and expenses are translated at exchange rates at the dates of the transactions (or average rates where relevant) and the resulting exchange differences are recognised in other comprehensive income and accumulated in a separate component of equity (translation surplus). Thus, they do not create income statement or cash flow exposure. This reserve represents a deferred gain or loss, which will be recognised in profit or loss upon disposal of the foreign operation.
It should be noted that when the functional currency of the subsidiary is the same as the functional currency of the parent, even if the subsidiary operates abroad, the translation of foreign currency transactions conducted by the subsidiary should be done in the same manner as translation of foreign currency transactions conducted by the parent itself, since the rationale for deferring exchange differences does not apply.
What is the scope of IAS 21?
IAS 21 deals with the determination of an entity’s functional currency, the translation of foreign currency transactions as well as foreign operations, and the translation of financial statements from the functional currency to a presentation currency. The Standard distinguishes between presentation currency and functional currency: while a reporting entity has no choice regarding its functional (measurement) currency and must determine the currency that reflects its operations, the Standard allows the reporting entity to present its financial statements in any currency it chooses (presentation currency). The method of translation from the functional currency to the presentation currency is the same as the method required for translating a foreign operation for inclusion in the reporting entity’s financial statements