1. Chapter 7 Accounting for Foreign Currency © 2013 Advanced Accounting, Canadian Edition by G. Fayerman

2. Determining the Functional Currency of a Company A company must prepare its financial statements using its functional currency to measure its results. (IAS 21) Functional currency is the currency of the country where the company conducts its primary business activity. The currency of the country in which a company normally operates is not necessarily its functional currency. Often a company's functional currency is the same as that of the nation in which it is headquartered, though this is not necessarily the case. The functional currency is the most relevant currency for multinational corporations that conduct business in multiple currencies. LO 1

3. Foreign Currency Exchange Gains and Losses Functional currency must be determined first before foreign currency transactions can be identified. Once a transaction is denominated in a currency that a company does not typically deal in, the company has now exposed itself to foreign currency risk. Foreign currency risk is affected by the changes in the foreign currency relative to its domestic currency. LO 1

4. Foreign Currency Exchange Gains and Losses You have just started up your own Internet-based business selling trendy toys worldwide. You have a local Canadian toy supplier. You believe you will be most profitable selling online and so you have created a website where people can order directly from you. There are basically three options available for structuring the sales transactions: o Option 1: Display the toys on the website with a selling price in C$ and receive a C$ payment from your customers. o Option 2: Display the toys on the website with a selling price in C$ and receive a foreign currency payment (e.g., US$) from your customers. o Option 3: Display the toys on the website with a selling price in a foreign currency (e.g., US$) and receive a foreign currency payment (e.g., US$) from your customers. Option 1, the company is not exposed to foreign currency risk (the customer is), however, in option 2 and option 3, the company is exposed to foreign currency risk. LO 1 Example 7.2

5. Primary Economic Activity In order to identify the foreign exchange component of a transaction, a company must establish the currency in which its books and records should be maintained. This is the currency of the primary economic environment in which a company operates. It cannot be assumed that a company’s domestic currency is the currency in which it normally operates. Sometimes, a company’s domestic currency can be the Canadian dollar because that is where its offices are located. But if the company sells most of its products to another country such that the economic activities of that foreign country mainly influence the pricing and sales of the company’s products and services, that foreign currency likely would be determined to be its functional currency (IAS 21.9 and.10). LO 1

6. Converting Foreign Currency Transactions Into a Company’s Functional Currency Once a company’s functional currency is identified, all transactions denominated in another currency are considered to be foreign currency transactions. (IAS 21.20) Examples of foreign currency transactions: o A company buys or sells goods or services whose price is denominated in a foreign currency. o A company borrows or lends money when the amounts payable or receivable are denominated in a foreign currency. o A company acquires or disposes of assets, or incurs or settles liabilities, denominated in a foreign currency. LO 2

7. Initial Recognition When a company enters into transactions denominated in a foreign currency, it is required to translate those transactions into the company’s functional currency for inclusion in its accounting records and financial statements. An exchange rate is the price to change one currency into another. When initially entered into, the transaction is converted at the spot exchange rate at the date of the transaction. The spot exchange rate is the price to change one currency into another at the time of the transaction. The average exchange rate is the mathematical average of multiple spot exchange rates. LO 2

8. Recognition in Subsequent Periods: Monetary Items Monetary items are identified as money held and items to be received or paid in money or in a fixed or determinable number of units of currency (IAS 21.16). Monetary items that are denominated in a foreign currency must be translated using the closing rate of exchange at the end of the reporting period. Any resulting foreign exchange gains or losses are recognized in income. LO 2

9. Recognition in Subsequent Periods: Monetary Items Reporting Current Monetary Item Subsequent to the Transaction Date On November 15, 2013, Local Corporation sold merchandise to a customer located in Europe. The sale, denominated in euros, amounted to €100,000. On November 15, 2013, the foreign currency rate was €1 = C$1.3782. At December 31, 2013, Local’s year end, the account still had not been collected, and the foreign currency rate was €1 = $1.4010. The following entry would be required on November 15, 2013 (transaction date) to record the transaction in Local’s accounting records in Canadian dollars (functional currency = C$): Accounts Receivable 137,820 Sales 137,820 [To record merchandise sold in C$ (= €100,000 × 1.3782)] At year end, on December 31, 2013, the monetary items will be remeasured at the spot exchange rate as follows: Accounts Receivable 2,280 Foreign Exchange (NI) 2,280 [To record fluctuation in foreign currency rate on monetary item denominated in a foreign currency at year end. You will note that this gain goes directly to net income (€100,000 × [1.4010 – 1.3782]). LO 2 Example 7.6

10. Recognition in Subsequent Periods: Non-monetary Items Non-monetary items are all items other than monetary items. Their values are not fixed by contract or in a determinable number of currency units. Non-monetary items that are measured in terms of historical cost in a foreign currency were initially translated at the spot rate at the day of the transaction. These items are not subject to foreign currency risk since the company has the ability to affect the amount the item is sold or bought for since it is not fixed in amount by contract. IAS 21 requires that in subsequent periods, the non-monetary items be translated using the exchange rate at the date of the original transaction. This spot rate is referred to as the historical exchange rate in subsequent periods as it has not changed since the transaction date. LO 2

11. Recognition in Subsequent Periods: Non-monetary Items Subsequent Reporting of Current Non-monetary Items On November 15, 2013, Local Corporation purchased inventory from a supplier located in Europe. The purchase, denominated in euros, amounted to €100,000 and was paid for immediately in cash. On November 15, 2013, the foreign currency rate was €1 = C$1.3782. At December 31, 2013, Local’s year end, the foreign currency rate was €1 = $1.4010. The following entry would be required on November 15, 2013 (transaction date) to record the transaction in Local’s accounting records in Cdn dollars (functional currency = C$): Inventory 137,820 Sales 137,820 [To record purchase of inventory in C$ (= €100,000 × 1.3782)] At year end, on December 31, 2013, no entry since inventory is non-monetary and is not re-translated at year end. The non- monetary items will be reported at their historical exchange rate. LO 2 Example 7.8

12. Non-monetary Items Reflected at Fair Value in Subsequent Periods In IFRS, companies may record some non-monetary items at fair value in the currency of the transaction (i.e., inventory must be reported at the LCNRV; PPE may be reflected using the revaluation model; and investment property may be reflected using the fair value method). Non-monetary items that are measured at fair value in a foreign currency must be translated using the exchange rates at the date when the fair value was determined. It is counterintuitive to apply a historical rate to an asset that is reflected at a current value. Any resulting foreign exchange gain or loss is recognized in income unless the transaction giving rise to this foreign exchange is recognized in Other Comprehensive Income, in which case, the foreign exchange component is also recognized in Other Comprehensive Income. LO 2

13. Converting Foreign Currency Transactions into a Company’s Functional Currency: Summary Transactions denominated in a foreign currency are translated at the date the transaction is initially recognized in the company’s accounts using the spot exchange rate. At the statement of financial position date: o Monetary items are translated using the exchange rate at the statement of financial position date. Any resulting foreign exchange gain or loss is recorded in income. o Non-monetary items carried at cost are not adjusted to take into account changes in foreign exchange rates. o Non-monetary items carried at fair value are translated using the exchange rate in effect when the fair value was determined. Any resulting foreign exchange gain or loss is recorded in income unless the transaction to which the foreign exchange relates was initially recognized in comprehensive income, in which case the foreign exchange component is recognized in comprehensive income as well. LO 2

14. Applying Hedge Accounting to Foreign Currency Transactions In its simplest terms, hedging means the elimination of risk. There are many different types of risk – credit risk, interest rate risk, foreign currency risk, etc. LO 3

15. Economically Hedging Foreign Currency Risk A company that enters into several transactions denominated in foreign currencies exposes itself to risks that the foreign currencies will fluctuate, thereby causing it to realize foreign exchange losses. As a result, a company may decide to protect itself from this risk exposure by entering into transactions that cause an offsetting risk exposure. LO 3

16. Economically Hedging Foreign Currency Risk Sometimes, companies enter into transactions that naturally achieve offsetting risks. LO 3 Example 7.13

17. Economically Hedging Foreign Currency Risk As a result of Abco entering into two offsetting transactions, the company naturally protected itself from exposure to foreign currency fluctuations. This is commonly referred to as economically hedging risk. In this case, the change in value of the Canadian dollar relative to the Mexican peso on the purchase transaction was offset by an equal change in value on the sale. In addition, this hedge does not cost the company anything. Usually these hedges will not eliminate all risk as the timing and amount of the receivable and the payable will not be exactly the same. A profitable company will always have sales that are larger than its purchases so it will still be subject to risk on the profit. LO 3 Example 7.13

18. Derivative Financial Instruments as Hedges: Speculating in Foreign Currency Financial Instruments Companies sometimes purchase derivative financial instruments to speculate on future foreign currency movements, or to protect themselves from future fluctuations in currency rates. There are several different types of derivative financial instruments, such as financial options, futures or forward contracts, interest rate swaps, and currency swaps. A forward contract, for example, is a contract where two parties agree to exchange currencies at a set price in the future. However, since the foreign currency rate fluctuates constantly, this contract will also fluctuate in value. The value of forward contracts (which are considered a type of derivative financial instrument) is required to be recorded in the accounting records. Under IFRS 9, forward contracts are measured at fair value through profit or loss at each reporting date. LO 3

19. Derivative Financial Instruments as Hedges: Hedging with Financial Instrument Derivatives Companies often do not have natural hedges that inherently protect them from foreign currency fluctuations. In this case, a company would have to create an offsetting risk exposure. In other words, to hedge the risk of currency fluctuations, a company creates a foreign currency position opposite to that it wishes to protect. The concept of risk infers that the company could either receive a gain or suffer a loss on the fluctuation of the foreign exchange rates between purchase and payment dates. This potential lost “gain” from hedging the risk is an opportunity cost that is not reflected on financial statements. This opportunity cost is less important to the company. What the company wants to do is eliminate “risk,” which is the unknown. LO 3

20. Definition of Hedge Accounting Hedge accounting refers to the application of special accounting rules that allow a company to modify the regular accounting for foreign exchange gains and losses. For the purpose of hedge accounting, the item that creates a risk exposure for the company is referred to as the “ hedged item,” while the offsetting position created is referred to as the “ hedging item.” LO 3

21. Definition of Hedge Accounting In order to qualify to use special hedge accounting rules, the hedge must be highly effective. This means that the strategy used by the company to protect itself from foreign currency risk exposure was highly effective at achieving an offsetting risk exposure. For example, when the critical terms of the hedging item exactly match those of the hedged item, the hedge is considered highly effective. In order for a cash flow hedge to be effective, the changes in the cash flows of the hedge and the item it is hedging must offset during the term of the hedge and occur during the term of the relationship. In other words, when a hedge is perfectly effective, there are no overall exchange gains or losses reflected in profit. It is possible that a hedge is only partially effective. LO 3

22. Applying Hedge Accounting IAS 39 Financial Instruments: Recognition and Measurement, IFRS 9 Financial Instruments, and ASPE Section 3856 Financial Instruments require derivative financial instruments to be measured at fair value, with changes in fair value recognized in income (unless they are designated in effective hedging relationships). Hedges can be designated for hedge accounting purposes as being either cash flow hedges or fair value hedges. LO 3

23. Applying Hedge Accounting In cash flow hedges, a company uses a hedging item (that is, it creates an offsetting risk exposure by purchasing a derivative contract) to hedge against future fluctuations in the Canadian dollar value of future cash flows (a risk exposure already faced by the company, such as future payments). The gain or loss on the hedging item is initially reported in Other Comprehensive Income and subsequently reclassified to net income when the hedged item affects net income. LO 3

24. Applying Hedge Accounting In fair value hedges, a company uses a hedging item to protect itself against the fluctuations in the fair value of a hedged item (a risk exposure that already exists). The gain or loss on both the hedged and hedging items are recognized in profit or loss at the same time so that the impact on profit or loss are offset. This is rarely used for hedging foreign currency risk and is therefore not considered in this textbook. LO 3

25. Applying Hedge Accounting to Foreign Currency Transactions: Summary Companies try to manage their foreign currency risk by entering into transactions that cause offsetting risk exposures. This is sometimes referred to as economically hedging a risk. Hedge accounting refers to a special set of accounting rules that allow a company to smooth the impact of foreign currency fluctuations on income. LO 3

26. Applying Hedge Accounting to Foreign Currency Transactions Summary Without the use of hedge accounting, an increased volatility on income would be realized resulting from a company’s exposure to foreign currency risk. Under hedge accounting—cash flow hedge, IFRS records the changes in the hedging item (the forward contract) in Other Comprehensive Income until the hedged item (the balance exposed to foreign currency risk) affects income. Once foreign currency risk affects income on the hedged item (i.e., once foreign exchange gains and losses are realized), the corresponding fair value changes on the hedging item that have been accumulating in Other Comprehensive Income are transferred to income to offset the foreign exchange, thereby eliminating income volatility. LO 3

27. Translating Financial Statements from the Functional Currency to the Presentation Currency Financial statements can be presented in any currency. When a company selects a presentation currency for its financial statements that is different than its functional currency, the statements must be translated into the presentation currency. Upon translation, assets and liabilities are translated at the closing rate at the presentation date and income statement items are translated using the average rate for the period. Any gain or loss on translation is considered part of other comprehensive income since there is no real effect on present or future cash flows of the company. LO 4

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