An entity may carry foreign activities either by having foreign operations or by conducting transactions in foreign currencies. An entity may also present its financial statements in a foreign currency. The aim of this accounting standard is to prescribe how to include foreign operations and foreign currency transactions in the financial statements of an entity. In addition, the standard also provides guidance with regards to the translation of financial statements into a presentation currency/ reporting currency.
The core issues this standard deals with include determining the exchange rate(s) to be used when translating foreign transactions and foreign operations into the reporting currency and how to treat the effect of changes in the rates of exchange in the financial statements.
This standard should be applied in the following circumstances:
- When accounting for balances and transactions in foreign currencies except for those derivative transactions that fall within the scope of IFRS 9 Financial Instruments;
- When translating the financial position and performance of foreign operations that are included in an entity’s financial statements either by consolidation or through equity method; and
- When translating the financial position and results of an entity into a presentation currency.
In addition, this standard is also applicable to the presentation of the financial statements of an entity in a foreign currency and specifies requirements for the resulting financials to be classified as complying with the International Financial Reporting Standards (IFRSs).
However, this standard is not applicable to hedging of items that are denominated or valued in foreign currency including hedging of an investment in a foreign operation.
It also does not apply to the presentation of cash flows resulting from foreign currency transactions in a statement of cash flows of an entity or to the translation of cash flows of an entity’s foreign operation(s).
Definitions of Important Terms Used in the Standard
A functional currency can be defined as the currency of the primary economic environment in which an entity operates.
Presentation currency is the currency in which the financials of an entity are presented.
Foreign currency is a currency other than an entity’s functional currency.
It is the spot exchange rate at the end of an entity’s reporting period.
Spot Exchange Rate
It can be defined as the rate of exchange for immediate delivery.
It can be defined as the exchange ratio for two currencies.
It can be defined as the price that would be received against selling an asset or paid for transferring a liability in an orderly transaction among market participants at the measurement date.
Foreign operation is any entity that is a subsidiary, associate, branch, or a joint arrangement of a reporting entity, the operations/ activities of which are conducted in a currency other than the currency of the reporting entity.
Monetary items are units of currency held and assets/ liabilities to be received/ paid either in a fixed or determinable number of currency units.
Net investment in a Foreign Operation
It is the amount of interest of a reporting entity in the net assets of another entity or operation.
Factors Considered for Determining Functional Currency
An entity’s management primarily considers the following factors when determining its functional currency:
- Currency that influences the sale prices of goods and services.
- Currency of the country whose regulations as well as competitive forces play a critical part in determining sale prices of goods and services.
- Currency which mainly influences input costs such as material, labor and other costs necessary for making goods or services available for sale.
The following factors could also be looked upon when determining an entity’s functional currency:
- Currency in which an entity generates funds from financing activities such as issuing equity and debt instruments.
- Currency in which receipts from operating activities are generally retained by the entity.
In determining the functional currency of an entity’s foreign operation and whether the functional currency of both the entity and its foreign operation is the same or not, it is important to consider the following additional factors:
- Whether the business activities of a foreign operation are being carried out as an extension of the business activities of the reporting entity, instead of being carried out with a certain degree of independence and autonomy.
- Whether transactions conducted by the foreign operation with the reporting entity are a low or high proportion of the foreign operation’s overall business activities
- Whether cash flows generated from the activities of the foreign operation directly impact the reporting entity’s cash flows, and are readily distributable to it; and
- Whether the cash flows of the foreign operation are sufficient for covering the existing and expected debt obligations without any monetary assistance by the reporting entity.
Foreign Currency Transactions
A foreign currency transaction can be described as any transaction that is either denominated or requires to be settled through payment in a foreign currency, including transactions resulting when any entity:
- purchases or sales a product or service whose price is denominated in a foreign currency;
- Lends or borrows funds when the amounts receivable or payable are denominated in a foreign currency;
- Acquires or disposes off operating fixed assets or incurs and settles liabilities denominated in a foreign currency.
A foreign currency transaction should be recorded, on initial recognition in the functional currency, at the spot exchange rate between the foreign and the functional currency at the date at which the transaction occurs.
The transaction date is the date at which a specific transaction qualifies to be recognized as a foreign currency transaction in accordance with all the relevant IFRSs.
Reporting at the end of Each Subsequent Reporting Period
At the end of a reporting period:
- All the monetary items that are in a foreign currency should be translated by making use of the closing rate;
- All the items that are of non-monetary nature but are measured using the historical cost method in a foreign currency should be translated by making use of the rate of exchange at the date at which the transaction occurred; and
- All non-monetary items that are carried at fair value in a foreign currency should be translated using the rate of exchange at the date at which the fair value was measured.
Exchange differences resulting from translation or settlement of monetary items at rates different from the ones at which these items were initially recognized during the financial period or in prior financial statements, should be recognized in the statement of profit or loss in the financial period in which the exchange differences arise unless these differences relate to monetary items that are an important part of the net investment of a reporting entity in a foreign operation.
Exchange differences relating to monetary items that are part of a net investment of a reporting entity in a foreign operation should be recorded in the statement of profit or loss as part of the individual financial statements of the foreign operation or the separate financial statements of the reporting entity as appropriate. In case of financial statements that include financial results of both the reporting entity and the foreign operation (for example, consolidated financial statements if the foreign operation is a subsidiary of a reporting entity), such exchange differences should initially be recognized in the statement of other comprehensive income and reclassified from equity to statement of profit or loss on disposal of the net investment.
When any gain or loss related to a non-monetary item is recognized or presented in the statement of other comprehensive income, any exchange component of that gain or loss should be recognized or presented in the statement of other comprehensive income. Similarly, any gain or loss arising on a non-monetary item is recorded as part of the statement of profit or loss then any exchange component relating to that gain or loss should also be recognized or presented in the statement of other comprehensive income.
Change in Functional Currency
When there is a change in the functional currency of an entity then the translation procedures applicable to the new functional currency will be applied prospectively from the date at which the change is made.
Translation to Presentation Currency
An entity may present its financials in any currency. If an entity’s presentation currency and functional currency are different then the entity would be required to translate its financial position and results in its presentation currency.
The financial results of an entity whose functional currency is not that of a hyperinflationary economy should be translated into the entity’s presentation currency by following the below-mentioned procedures:
- Assets and liabilities presented in a statement of financial position including comparatives should be translated using the closing rate at the financial position date;
- Income and expenses presented in each statement of profit or loss and other comprehensive income should be translated using the exchange rates at the date at which the transactions occurred; and
- Any resulting exchange differences should be recognized in the statement of other comprehensive income.
The financial position and results of an entity functional currency are that of a hyperinflationary economy should be translated/ converted into a different presentation currency by following the below-mentioned procedures:
- All transaction amounts and account balances (income, expenses, assets, equity items, and liabilities should be translated by making use of the closing rate at the most recent balance sheet/ statement of financial position date;
- When translating balances into the currency of a non-hyperinflationary economy, it should be ensured that comparative amounts should be those that were presented in the previous year’s financial statements and should not be adjusted for any subsequent changes in exchange rates.
Additional Factors to Consider When Translating Financial Results of a Foreign Operation
Normally, when the financial position and financial results of a foreign operation are merged with those of the reporting entity then consolidation procedures are followed such as elimination of intragroup transactions and balances with a subsidiary. However, an intragroup monetary asset and liability whether long-term or short-term cannot be eliminated without displaying the results of currency fluctuations in the consolidated financial statements.
Any goodwill resulting from the acquisition of a foreign operation and any fair value adjustments to the carrying values of liabilities and assets arising on the foreign operation’s acquisition should be treated as liabilities and assets of the foreign operation. Thus they should be recorded in the foreign operation’s functional currency and should be translated using the closing rate.
Disposal of a Foreign Operation
When a foreign operation is being disposed of, the cumulative amount of exchange differences relating to that foreign operation, should be presented in the statement of other comprehensive income and accumulated in a separate account held under the component of equity. When gain or loss on disposal of the foreign operation is recognized then exchange differences first classified in equity should be reclassified to the statement of profit or loss as a reclassification adjustment.
Tax Effects of Exchange Differences
Gains and losses on foreign currency transactions and exchange differences arising on translation of the financial position and results of an entity (including a foreign operation) into a different currency may have tax effects. These tax effects will be dealt with by IAS 12 Income Taxes.
An entity is required to give disclosures with regards to the following:
- The exchange differences recognized in the statement of profit or loss baring those that arise on financial instruments that are measured at fair value model through the statement of profit or loss in compliance with IFRS 9;
- Exchange differences that have been recognized in the statement of other comprehensive income and accumulated separately under the equity component and a reconciliation of such exchange difference both at the beginning and the end of the period.
- The fact that an entity’s functional currency is different from its presentation currency together with the disclosure stating the name of the functional currency and the reason behind using a different currency for the presentation of financial results and position.
- Any change in the functional currency of a foreign operation or its reporting entity and the reason behind the change in currency.
- When any entity presents its results and financial position in a currency that is different from its functional currency then it should state that financial statements comply with IFRSs only if they comply with the requirements of all the applicable IFRSs.
- When an entity presents its financial statements or other finance-related information in a currency that is different from either its presentation currency or functional currency and the financial statements also fail in complying with the requirements of all the applicable IFRSs then the entity should do the following:
- Clearly identify the information not complying with the IFRSs as supplementary information to separate or distinguish it from the information that indeed complies with the requirements of the IFRSs;
- Disclose the name of the currency in which the supplementary information is presented;
- Disclose the entity’s functional currency as well as the method it uses for translating supplementary information.