1. International Financial Reporting and Analysis, 5 th edition David Alexander, Anne Britton and Ann Jorissen ISBN 978-1-4080-3228-2 © 2011 Cengage Learning EMEA Chapter 29 Foreign currency translation

2. International Financial Reporting and Analysis, 5 th 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

3. International Financial Reporting and Analysis, 5 th 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

4. International Financial Reporting and Analysis, 5 th 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: £

5. International Financial Reporting and Analysis, 5 th 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 receivable211 006 Cr. Sales account211 006 01.08.20X2: 750 000 / 3.7081 = 202 260 Dr. Cash202 260 Cr. Accounts receivable202 260 Acc. Receivables : £8 746 = loss on exchange (IS) In case exchange rate has decreased: profit on exchange

6. International Financial Reporting and Analysis, 5 th 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 00630.6.X2 loss 5 937 Balance 205 069 211 006 1.7.X2 balance 205 0691.8.X2 cash 202 260 30.06.X3 loss 2 809

7. International Financial Reporting and Analysis, 5 th 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

8. International Financial Reporting and Analysis, 5 th 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

9. International Financial Reporting and Analysis, 5 th 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 FCAccounts payable in FC 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

10. International Financial Reporting and Analysis, 5 th 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

11. International Financial Reporting and Analysis, 5 th 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

12. International Financial Reporting and Analysis, 5 th 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

13. International Financial Reporting and Analysis, 5 th 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

14. International Financial Reporting and Analysis, 5 th 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

15. International Financial Reporting and Analysis, 5 th 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

16. International Financial Reporting and Analysis, 5 th 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 position 31.12.X4 FC Share capital300 Retained profits100 400 Equipment at cost350 Less Depreciation50300 Inventory80 Net monetary cur. assets 60140 Long-term loans(40) 400 Statement of income 31.12.X4 FC Sales600 Less cost of sales(400) Gross profit200 Less depreciation(50) Less other expenses(50) 100

17. International Financial Reporting and Analysis, 5 th 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 X45 Average for the year to 31 December X44.5 Average for closing inventory acquisition4.6 31 December X44.2 Statement of income 31.12.X4RateCrs Sales4.5133.3 Less cost of sales4.588.9 Gross profit44.4 Less depreciation4.211.9 Less other expenses11.123 21.4

18. International Financial Reporting and Analysis, 5 th 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.X4RateCrs Share capital560 Retained profits21.4 Exchange difference13.895.2 Equipment at cost4.283.3 Depreciation4.211.971.4 Inventory4.219 Net monetary current assets 4.214.3 Long-term loans4.2(9.5)23.8 95.2

19. International Financial Reporting and Analysis, 5 th 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

20. International Financial Reporting and Analysis, 5 th 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

21. International Financial Reporting and Analysis, 5 th 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

22. International Financial Reporting and Analysis, 5 th 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

23. International Financial Reporting and Analysis, 5 th 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

24. International Financial Reporting and Analysis, 5 th 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 ItemTranslation rate Cost and depreciation of PPE and intangible assets Rate at date of acquisition or fair valuation date InventoriesRate when cost incurred Monetary itemsClosing rate Income and expense itemsRate at date of acquisition or average rate for period if rates do not fluctuate significantly Exchange differencesStatement of income

25. International Financial Reporting and Analysis, 5 th 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 ItemTranslation rate All assets and liabilities (whether monetary or non- monetary) Closing rate Income or expense itemsRate at date of acquisition or average rate for period if rates do not fluctuate significantly Exchange differencesEquity

26. International Financial Reporting and Analysis, 5 th 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

27. International Financial Reporting and Analysis, 5 th 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 31.12.X8 FC Share capital300 000 Retained profits40 000 340 000 Equipment at cost350 000 less Depreciation35 000 315 000 Inventory105 000 Net mon. cur. assets20 000 less long-term loans(100 000) 340 000 Statement of income X8 Tickets Sales450 000 Less cost of sales(360 000) Gross profit90 000 Less depreciation(35 000) Less other expenses (15 000) Net profit40 000

28. International Financial Reporting and Analysis, 5 th 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 income year 8 RateClosingTemporalRate Sales1140 909 11 Less cost of sales1132 727 11 Gross profit8 182 Less depreciation10(3 500)(2 917)12 Less other expenses11(1 364) 11 Net profit3 3183 901

29. International Financial Reporting and Analysis, 5 th 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 31.12.x8 RateClosingTemporalRate Share capital25 000 Retained profits3 3183 901 28 31828 901 Equipment at cost1035 00029 16712 less Depreciation103 5002 91712 31 50026 250 Inventory1010 50010 00010.5 Net monetary current assets102 000 10 less long-term loans10(10 000) 10 34 00028 250 Exchange difference(5 682)651 28 31828 901

30. International Financial Reporting and Analysis, 5 th 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)

31. International Financial Reporting and Analysis, 5 th 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

32. International Financial Reporting and Analysis, 5 th 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.

33. International Financial Reporting and Analysis, 5 th 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