Chapter 29
Foreign currency translation
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
Contents
• Introduction
• Currency conversion
• Currency translation
• IAS 21 requirements for individual
enterprise’s foreign currency transactions
• Translation methods for financial statements
of foreign operations
• IAS 21 rules for translation of financial
statements of foreign operations
• Financial reporting in hyperinflationary
economies
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
Learning objectives
• Explain the necessity for foreign currency
conversion and translation
• Describe the IAS regulations in respect of foreign
currency transactions for individual enterprises
• Appraise the position where foreign currency
investments and borrowings are matched
• Critically appraise the IAS regulations in respect of
translation of the accounts of foreign branches and
subsidiaries etc.
• Translate accounts of foreign enterprises
• Describe the disclosure requirements of IAS
regulations in respect of foreign currency translation
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
Currency conversion
• Required when a foreign currency transaction is
completed within an accounting period
• Two events:
– the purchase or sale of an asset or the incurring of an expense
or item of income
– the receipt or payment of monies for these assets, expenses or
items of income
• Example:
– UK company sells goods to a Swiss company on 1 May 20X2
for SWFr 750 000. Payment on 1 August 20x2
Exchange rate 1 May 20X2: £1 = SWFr 3.5544
Exchange rate 1 August 20X2: £1 = SWFr 3.7081
Year end: 30 September 20X2; reporting currency: £
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
Currency conversion
(cont’d)
01.05.20X2: 750 000 / 3.5544 = 211 006
Dr. Accounts receivable 211 006
Cr. Sales account 211 006
01.08.20X2: 750 000 / 3.7081 = 202 260
Dr. Cash 202 260
Cr. Accounts receivable 202 260
Acc. Receivables : £8 746 = loss on exchange (IS)
In case exchange rate has decreased: profit on
exchange
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
Currency conversion
(cont’d)
Year end 30 June 20X2; exchange rate £1= SWFr 3.6573
30.06.20X2:
Acc. Receiv. would be £205 069 instead of £211 006
Difference of £5 937 loss of exchange (IS)
01.08.20X2: Payment of the debt:
Further loss of £ 2 809 (so that total loss of £8 746 is split over two
years) Accounts receivable
1.5.X2 sales 211 006 30.6.X2 loss 5 937
Balance 205 069
211 006 211 006
1.7.X2 balance 205 069 1.8.X2 cash 202 260
30.06.X3 loss 2 809
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
Currency conversion
(cont’d)
• Loss of exchange on year end in income statement
following the idea of prudence
• Assume exchange rate £1 = 3.4973
• Year end acc. receivable = £214 451
• Profit on exchange = £3 445
• 1 August 20X2: loss of £12 191
• Gain of £3 445 is unrealized gain so that question
arises whether or not to recognize this gain
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 requirements for individual
enterprise’s foreign currency
transactions
• Exchange differences arising on the settlement of monetary items or on
translating monetary items at rates different from those at which they were
translated on initial recognition during the period, or in previous financial
statements, should be recognized in profit or loss in the period in which they
arise
• When monetary items arise from a foreign currency transaction and there is
a change in the exchange rate between the transaction date and the date of
settlement, an exchange difference results. When the transaction is settled
within the same accounting period as that in which it occurred, all the
exchange difference is recognized in that period. However, when the
transaction is settled in a subsequent accounting period, the exchange
difference recognized in each period up to the period of settlement is
determined by the change in exchange rates during each period
• Thus, an unrealized gain to be recognized in the accounts
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 requirements
(cont’d)
• Activity 29.3:
– 1.3.X2: Purchase of an asset: € 10.000 and exchange rate
1FC = 2€; functional currency is FC
– 30.6.X2: balance sheet date: exchange rate 1FC = 1€
Assets in FC Accounts payable in FC
1.3.X2 5 000 1.3.X2 5 000
Exc. diff. 5 000
– monetary items: closing rate
– non-monetary items carried at HC: exchange rate acquisition
date
– non-monetery items at fair value: exchange prevalent when FV
was determined
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 requirements
(cont’d)
• Reporting currency
– Functional currency :
• currency of the primary economic environment in which
the entity operates
– Presentation currency
• currency in which the financial statements are presented
– Primary economic environment:
• the one in which the entity primarily generates and
expends cash
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 requirements
(cont’d)
– Factors to determine functional currency:
• The currency:
– that mainly influences sales prices for goods and services;
and
– of the country whose competitive forces and regulations
mainly determine the sales prices of its goods and services
• The currency that mainly influences labour, material and
other costs of providing goods or services
– Following factors also provide evidence of
functional currency:
• the currency in which funds from financing activities are
generated
• the currency in which receipts from operating activities
are usually retained
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 requirements
(cont’d)
– Additional factors:
• 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
• whether transactions with the reporting entity are a high or low
proportion of the foreign operation’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
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 requirements
(cont’d)
• Example:
– An entity operating in France owns several
buildings in Paris that are rented to foreign
companies, mostly US companies. The lease
contracts are determined in US dollars and
payment can be made in either US dollars or
Euros
– Functional currency = EURO
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 requirements
(cont’d)
– A US entity has a foreign subsidiary located in
Greece. The Greek subsidiary imports a product
manufactured by its parent, paying in dollars,
which it sells throughout Greece with selling prices
denominated in Euros and determined primarily by
local competition. The subsidiary’s long-term
financing is primarily in the form of dollar loans
from its parent and distribution of its profits is
under parental control. Proceeds of the subsidiary
are remitted to the parent on a regular basis
– Functional currency = DOLLAR
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 requirements
(cont’d)
• Translation from functional to presentation currency
occurs as follows:
1. assets and liabilities for each statement of
financial position presented shall be translated at
the closing rate at the date of that statement of
financial position
2. income and expenses for each income
statement shall be translated at exchange rates
at the date of the transactions
3. all resulting exchange differences shall be
recognized as a separate component of equity
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 requirements
(cont’d)
Zhou Ltd Statement of financial Statement of income
position 31.12.X4 31.12.X4
FC FC
FC
Share capital 300
Retained profits 100 Sales 600
400 Less cost of sales (400)
Equipment at cost 350 Gross profit 200
Less Depreciation 50 300
Inventory 80 Less depreciation (50)
Net monetary cur. assets 60 140 Less other expenses (50)
Long-term loans (40) 100
400
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 requirements
(cont’d)
Presentation currency Zhou Ltd is Crowns (Cr) FC to Cr
1 January X4 5
Average for the year to 31 December X4 4.5
Average for closing inventory acquisition 4.6
31 December X4 4.2
Statement of income 31.12.X4 Rate Crs Crs
Sales 4.5 133.3
Less cost of sales 4.5 88.9
Gross profit 44.4
Less depreciation 4.2 11.9
Less other expenses 11.1 23
21.4
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 requirements
(cont’d)
Statement of financial position 31.12.X4 Rate Crs Crs
Share capital 5 60
Retained profits 21.4
Exchange difference 13.8 95.2
Equipment at cost 4.2 83.3
Depreciation 4.2 11.9 71.4
Inventory 4.2 19
Net monetary current assets 4.2 14.3
Long-term loans 4.2 (9.5) 23.8
95.2
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 requirements
(cont’d)
• Loans
– translated as any other monetary item at closing rate and the
exchange gain or loss credited or charged to income
• Investments matched by borrowings
– an asset, exposed to an exchange risk
– a liability also exposed to an exchange risk
– since asset and liability part of one overall transaction,
effects of exchange rate movements cancelled out
• Hedge accounting
– allowance to classify exchange differences as equity arisen
on a foreign currency liability used as hedge
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 requirements
(cont’d)
• Summary of individual enterprise transactions:
1. Settled transactions: gain or loss is obviously realized and
reflected in cash flows
2. Unsettled transactions: short-term monetary items
translate at year end exchange rate and gain or loss,
although unrealized, is taken to statement of income, as it
is reasonably certain
3. Long-term monetary items treated the same as short term
4. If a liability forms a hedge to a net investment then the
exchange difference on the liability is classified as equity
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
Translation methods for
financial statements of
foreign operations
• Two basic possible views:
– we can use the exchange rate ruling when the item was
created (historic rate)
– we can use the exchange rate ruling when the item is being
reported (current or closing rate)
• Different combinations:
– Single rate (closing rate)
• all assets, liabilities, revenues, expenses: closing rate
– Mixed rate (current/non current)
• current assets and liabilities: closing rate
• fixed assets and non-current liabilities: rate ruling when
the item was established
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
Translation methods etc
(cont’d)
– Mixed rate (monetary/non monetary)
– monetary assets and liabilities: closing rate
– all non-monetary assets and liabilities: rate
ruling when the item was established
– Mixed rate (temporal)
– assets recorded at HC: historic rate (rate ruling
when the item was established)
– assets recorded on a current value: closing rate
– revenues and expenses: rate ruling on the date
when the amount shown in the accounts was
established
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 Rules for translation of
financial statements of foreign
operations
• Determine functional currency
• Translate foreign currency into functional currency
using temporal method
• Exchange differences in P&L
• Translate functional currency in foreign currency
when necessary
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 Rules for translation
etc (cont’d)
Translation foreign currency into functional currency
Item Translation rate
Cost and depreciation of Rate at date of acquisition
PPE and intangible assets or fair valuation date
Inventories Rate when cost incurred
Monetary items Closing rate
Income and expense items Rate at date of acquisition
or average rate for period if
rates do not fluctuate
significantly
Exchange differences Statement of income
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 Rules for translation
etc (cont’d)
Translation functional currency into presentation currency
Item Translation rate
All assets and liabilities Closing rate
(whether monetary or non-
monetary)
Income or expense items Rate at date of acquisition
or average rate for period if
rates do not fluctuate
significantly
Exchange differences Equity
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 Rules for translation
etc (cont’d)
Home established a 100% ownership of Away on 1 January year 8
by subscribing to €25 000 of shares in cash when the exchange
rate was 12 ‘tickets’ to the €. Away raised a long-term loan of 100
000 tickets locally on 1 January year 8 and immediately purchased
equipment costing 350 000 tickets, which was expected to last ten
years with no residual value. It was to be depreciated under the
straight line method. The accounts of Away in the foreign currency
for year 8 follow, during which the relevant exchange rates were:
Tickets to €
1 January 12
Average for year 11
Average for period in which closing inventory acquired 10.5
31 December 10
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 Rules for translation
etc (cont’d)
Statement of financial position
Statement of income X8 31.12.X8
Tickets FC
Sales 450 000 Share capital 300 000
Less cost of sales (360 000) Retained profits 40 000
Gross profit 90 000 340 000
Less depreciation (35 000) Equipment at cost 350 000
Less other (15 000) less Depreciation 35 000
expenses 315 000
Net profit 40 000 Inventory 105 000
Net mon. cur. assets 20 000
less long-term loans (100 000)
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen 340 000
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 Rules for translation
etc (cont’d)
Statement of income year Rate Closing Temporal Rate
8
Sales 11 40 909 40 909 11
Less cost of sales 11 32 727 32 727 11
Gross profit 8 182 8 182
Less depreciation 10 (3 500) (2 917) 12
Less other expenses 11 (1 364) (1 364) 11
Net profit 3 318 3 901
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 Rules for translation
etc (cont’d)
Statement of financial Rate Closing Temporal Rate
position 31.12.x8
Share capital 25 000 25 000
Retained profits 3 318 3 901
28 318 28 901
Equipment at cost 10 35 000 29 167 12
less Depreciation 10 3 500 2 917 12
31 500 26 250
Inventory 10 10 500 10 000 10.5
Net monetary current assets 10 2 000 2 000 10
less long-term loans 10 (10 000) (10 000) 10
34 000 28 250
Exchange difference (5 682) 651
28 318 28 901
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
IAS 21 Rules for translation
etc (cont’d)
• Some other issues:
– Disposal:
• The cumulative amount of the exchange differences deferred
in the separate component of equity relating to that foreign
operation should be recognized in profit or loss
– Change in entity’s functional currency:
• Generally: not allowed
• Except when change in the underlying transaction events or
conditions (e.g. adoption of the euro)
• Translation into new functional currency at exchange rate of
the date of change; resulting translated amounts for non-
monetary items treated at their historical cost
– Disclosure requirements (see IAS 21, paras 51–57)
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
Financial reporting in
hyperinflationary economies
• Financial statements have to be dealt with in
accordance with IAS 29 before IAS 21 is
applied
– stated in the measuring unit current at the statement
of financial position date
• GAAP comparisons:
– IAS v UK
• FRS 23 convergent with IAS 21
– IAS v US
• SFAS 52 similar to IAS 21
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
Summary
• For individual entity transactions non-monetary items are
translated at originating exchange rate but monetary items at
statement of financial position rate if not settled. Thus unrealised
gains and losses due to foreign currency fluctuations will be
taken to the statement on income generally as part of ordinary
activities
• Foreign entities recording to functional currency use the
temporal method
• Foreign entities translating to presentation currency use the
closing rate for statement of financial position and average rate
for statement of income.
• Where exchange differences result from severe devaluations
and there is no practical means to hedge, these are carried as
part of the cost of the asset.
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
Summary contd.
• Foreign operations in hyperinflationary economies
have to be stated in the measuring unit current at the
statement of financial position date before translation
• IFRIC 16, Hedges of a net investment in a foreign
operation – was issued in July 2008 and should be
referenced for further guidance on hedging
International Financial Reporting and Analysis, 5th edition
David Alexander, Anne Britton and Ann Jorissen
ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA
