Chapter19 foreigncurrencytransactions2008

Gripping IFRS Foreign currency transactions

Chapter 19
Foreign Currency Transactions

Reference: IAS 21, IAS 39 and IFRS 7

Contents: Page

1. Definitions 599

2. Foreign currency transactions 599

2.1 General 599

2.2 How exchange rates are quoted 599
Example 1: quoted exchange rates 600

2.3 Transactions 600

2.4 Dates 600
2.4.1 Determining the transaction date 600
2.4.2 Determining the settlement date 601
2.4.3 Determining the translation date 601
Example 2: transaction, settlement and translation dates 601

2.5 Recognition and measurement 602
2.5.1 Initial recognition and measurement 602
2.5.2 Subsequent measurement: monetary items 602
2.5.2.1 Overview 602
2.5.2.2 Translation at the end of the reporting period 602
2.5.2.3 Translation at settlement date 603
2.5.2.4 Exchange difference 603
Example 3: exchange differences 603
2.5.3 Subsequent measurement: non-monetary items 604
Example 4: measurement of plant bought from foreign 605
supplier
Example 5: measurement of inventory owned by foreign 606
branch
Example 6: measurement of plant owned by foreign branch 607

2.6 Exchange differences on monetary items 608
2.6.1 Import and export transactions 608
2.6.1.1 Transaction and settlement on same day 608
Example 7: import transaction: settled on same day 608
Example 8: export transaction: settled on same day 609
2.6.1.2 Settlement deferred (credit transactions) 609
2.6.1.2.1 Settlement of a credit transaction before year-end 609
Example 9: import: credit transaction settled before year-end 609
Example 10: export: credit transaction settled before year-end 610
2.6.1.2.2 Settlement of a credit transaction after year-end 610
Example 11: import: credit transaction settled after year-end 611
Example 12: export: credit transaction settled after year-end 611
Example 13: import: credit transaction: another example 612
2.6.2 Foreign loans 614
Example 14: foreign loans 614

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Contents continued … Page

3. Presentation and functional currencies 615

3.1 General 615

3.2 Determining the functional currency 615

3.3 Accounting for a change in functional currency 616

3.4 Using a presentation currency other than the functional currency 616
3.4.1 Explanation of foreign currency translation reserve 616
Example 15: foreign currency translation reserve 617

4. Presentation and disclosure 618

5. Summary 619

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1. Definitions

The following definitions are provided:
• Exchange rate: is the ratio of exchange for two currencies.
• Spot exchange rate: is the exchange rate for immediate delivery.
• Closing Rate: is the spot exchange rate at the reporting date.
• Exchange difference: is the difference resulting from translating a given number of units
of one currency into another currency at different exchange rates.
• Fair value: is the amount for which an asset could be exchanged, or a liability settled,
between knowledgeable, willing parties in an arm’s length transaction.
• Foreign currency: is a currency other than the functional currency of the entity.
• Functional currency: is the currency of the primary economic environment in which the
entity operates.
• Foreign currency transaction: is a transaction that is denominated and/or requires
settlement in a foreign currency.
• Presentation currency: is the currency in which the financial statements are presented.
• Monetary items: are units of currency held and assets and liabilities to be received or
paid in a fixed or determinable number of units of currency.
• Transaction date: the date on which the risks and rewards of ownership transfer
(simplified definition: see the full definition from IAS 21).
• Settlement date: the date upon which a foreign debtor or creditor pays or is paid.
• Translation date: the date on which the balance in foreign currency is converted into
local currency (transaction date, settlement date and reporting dates).

2. Foreign currency transactions

2.1 General
Businesses frequently enter into transactions with foreign entities. These transactions
(involving incomes, expenses, assets and liabilities) may be denominated in foreign
currencies (e.g. an invoice that is in dollars, is referred to as ‘denominated in dollars’). Since
financial statements are prepared in one currency only, all foreign currency amounts must be
converted into the currency used for the financial statement (presentation currency). To
complicate matters, there is often a considerable time lag between the date that a foreign
debtor or creditor is created and the date upon which that debtor pays or creditor is paid. This
inevitably results in exchange differences because exchange rates fluctuate on a daily basis.
This chapter deals with IAS 21 – The Effects of Changes in Foreign Exchange Rates, which
sets out the method to be used in converting currencies for inclusion in financial statements.
2.2 How exchange rates are quoted
An exchange rate is the price of one currency in another currency. For example, if we have
two currencies, a local currency (LC) and a foreign currency (FC), we could quote the FC:LC
exchange rate as, for example, FC1:LC4. This effectively means that to purchase 1 unit of FC,
we would have to pay 4 units of LC. It is also possible to quote the same exchange rate as
LC1: FC0.25. This effectively means that 1 unit of LC would purchase 0.25 units of the FC.
Global market forces determine currency exchange rates. If you ask a bank or other currency
dealer to buy or sell a particular currency, you will be quoted an exchange rate that is valid for
that particular day only (i.e. immediate delivery). This exchange rate is called a ‘spot rate’.

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Example 1: quoted exchange rates

You are quoted a spot exchange rate on 1 March 20X1 of £1: $2.

Required:
A. If you had £1 000 to exchange (i.e. sell), how many $ would you receive (i.e. buy) from
the currency dealer?
B. If you had $1 000 to exchange (i.e. sell), how many £ would you receive (i.e. buy) from
the currency dealer?
C. Restate the exchange rate in the format £ …: $1.

Solution to example 1: quoted exchange rates

A: £1 000 / 1 x 2 = $2 000
B: $1 000 / 2 x 1 = £500
C: £1 / 2 = £0.5 therefore, the exchange rate would be £0.5: $1

2.3 Transactions

The types of foreign currency transactions that can be entered into are numerous. Common
examples of transactions with foreign entities include:
• borrowing or lending money;
• purchasing or selling inventory; and
• purchasing or selling depreciable assets.

2.4 Dates

Dates involved with foreign currency transactions are very important because exchange rates
differ from day-to-day. The following dates are significant when recording the foreign
currency transaction:
• transaction date – this is when a loan is raised/made or an item is purchased or sold;
• settlement date – this is when cash changes hands in settlement of the transaction (e.g. the
creditor is paid or payment is received from the debtor); and
• translation date – this is the financial year-end of the local entity.

The transaction is recognised on transaction date, which is the date on which the definition
and recognition criteria are met. The order date occurs before the transaction date. Since we
are normally not interested in the events before transaction date, the order date is normally
irrelevant.

2.4.1 Determining the transaction date

The first thing that must be determined in a foreign currency transaction is the transaction
date. The date on which the transaction must be recognised is established with reference to
the IFRS that applies to the type of transaction in question. A rule of thumb for a purchase or
sale transaction is that the transaction date would be when the risks and rewards of ownership
transfer from one entity to the other entity.

For regular import or export transactions, establishing the date that risks and rewards are
transferred is complicated by the fact that goods sent to or ordered from other countries
usually spend a considerable time in transit.

There are two common ways of shipping goods between countries. Goods can be shipped:
• Free on Board (F.O.B); or
• Cost, Insurance, Freight (C.I.F).

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If a transaction is arranged on a Free on Board (F.O.B) basis, the situation is:
• generally, as soon as the entity shipping the goods has delivered the goods to the port of
departure and they have been loaded onto a ship, the risks of the remaining voyage
transfers to the entity that will be receiving those goods; and therefore
• the transaction date will generally be the date that the goods are loaded onto a ship in the
originating country.

If a transaction is arranged on a Cost Insurance Freight (C.I.F) basis, the situation is:
• generally, the entity shipping the goods retains the risks of the voyage until the goods
arrive in the receiving port and are cleared through customs; and therefore
• the transaction date will generally be the date that the goods are offloaded at the
destination harbour and are cleared through customs.

The exact wording of the terms of the shipping documentation must, however, always be
investigated first before determining the transaction date.

2.4.2 Determining the settlement date

Next, the settlement date must be determined. The settlement date is the date on which:
• a foreign creditor is fully or partially paid; or
• full or partial payment is received from a foreign debtor.
The settlement date is generally not difficult to establish.

2.4.3 Determining the translation date (if applicable)

It is possible for a foreign currency transaction to spread over more than one financial year.
In other words, where such a transaction is spread over more than one financial year, at least
one year-end occurs between transaction date and settlement date. The year-end/s falling
between transaction and settlement date is known as the translation date.

Example 2: determining transaction, settlement and translation dates

On 13 January 20X4, Home Limited faxed an order for 1 000 yellow bicycles to Far Away
Limited, a bicycle manufacturer in Iceland.
On 16 January 20X4, Home Limited received a faxed confirmation from Far Away Limited
informing them that the order had been accepted.
On 25 January 20X4, Far Away Limited finished production of the required bicycles and
packed them for delivery.
On 1 February 20X4, the bicycles were delivered to one of Iceland’s many harbours and were
loaded onto a ship.
The ship set sail on 4 February 20X4.
Due to stormy weather it only arrived at the port in Home Limited’s country on
31 March 20X4.
The bicycles were offloaded and released from customs on the same day.
On 5 April 20X4, the bicycles finally arrived in Home Limited’s warehouse.
Far Away Limited was paid on 30 April 20X4.

Home Limited has a 28 February financial year-end. .

Required:
A. State the transaction, translation and settlement dates assuming the bicycles were
shipped F.O.B.
B. State the transaction, translation and settlement dates assuming the bicycles were
shipped C.I.F.

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Solution to example 2: determining transaction, settlement and translation dates

A.
The transaction date is 1 February 20X4: in terms of an F.O.B. transaction, the risks of ownership of
the bicycles would pass to Home Limited on the date the bicycles are loaded at the originating port.

The translation date is 28 February 20X4 since this is Home Limited’s year-end on which date the
foreign currency monetary item (foreign creditor) still exists, (the transaction date has occurred and the
settlement has not yet happened).

The settlement date is 30 April 20X4 being the date on which Home Limited pays the foreign creditor.

B.
The transaction date is 31 March 20X4: in terms of a C.I.F. transaction, the risks of ownership of the
bicycles would pass to Home Limited on the date that the bicycles are cleared from customs.

There is no translation date because at both 28 February 20X4 and 28 February 20X5 no foreign
currency monetary item (foreign creditor) existed. Thus there are no items to translate at either year-
end. (explanation: at 28 February 20X4 the transaction date had not yet occurred and
28 February 20X5 the foreign transaction had already been settled).

The settlement date is 30 April 20X4 being the date when the foreign creditor was paid.

2.5 Recognition and measurement

2.5.1 Initial recognition and measurement (IAS 21.20 - .22)

The foreign currency transaction is initially recognised on transaction date.

The foreign currency transaction is measured by:
• applying to the foreign currency amount
• the exchange rate between foreign currency and functional currency
• at the spot rate on transaction date.

It is permissible to use an average exchange rate for the past week or month as long as it
approximates the spot exchange rate.

2.5.2 Subsequent measurement: monetary items

2.5.2.1 Overview

As an exchange rate changes (and most fluctuate on a daily basis), the measurement of
amounts owing to or receivable from a foreign entity changes. For example, an exchange rate
of FC1: LC4 in January can change to an exchange rate of FC1: LC7 in February and
strengthen back to FC1: LC6 in March. Due to this, a foreign debtor or creditor will owe
different amounts depending on which date the balance is measured.

Monetary items (amounts owing or receivable) are translated to the latest exchange rates:
• on each subsequent reporting period; and
• on settlement date.

2.5.2.2 Translation at the end of the reporting period

If the monetary item is not settled by end of the reporting period, then an exchange difference
is likely to be recognised. This is because the item was originally measured at the spot rate on
transaction date. If it is not yet settled at the date a report is being drafted, the balance owing
or receivable will need to be re-measured at the spot rate on the date of the report. If there is

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a difference between the spot rate on transaction date and the spot rate on reporting date
(sometimes referred to as the closing rate), then an exchange difference arises.

2.5.2.3 Translation at settlement date

The amount paid or received is based on the spot rate on settlement date. If the spot rate on
transaction / reporting date (whichever is applicable) is different to the spot rate on settlement
date, an exchange difference will arise.

2.5.2.4 Exchange differences

The translation of monetary items will almost always result in exchange differences: gains or
losses (unless there is no change in the exchange rate since transaction date).

The exchange differences on monetary items are recognised in profit or loss in the period in
which they arise. ♥

♥ If the foreign exchange gain or loss relates to a foreign operation that is consolidated into
the entity’s books, then this exchange gain or loss will not be recognised in profit or loss
but rather in other comprehensive income. It would be reclassified as being part of profit
or loss only on disposal of the foreign operation. Consolidations are not covered in this
textbook and therefore this issue will not be covered further.

Example 3: exchange differences – monetary item

On 31 January an entity has a foreign debtor of FC2 000.
The local currency is denominated as LC and the foreign currency is denominated as FC.
The exchange rates of FC: LC are as follows:
31 January: FC1: LC4
28 February: FC1: LC7
31 March: FC1: LC6

Required:
A. Calculate the value of the foreign debtor in local currency units at the end of the months
January, February and March.
B. Calculate the exchange differences arising over those 3 months and in total.
C. Show how the debtor and exchange differences would be journalised in the entity’s books
on 31 January, 28 February and 31 March. Assume the debtor was created on 31 January
through a sale of goods. Ignore the journal required for the cost of the sale.

Solution to example 3: exchange differences – monetary item

A.
On 31 January the foreign debtor would be worth FC2 000 x LC4 = LC8 000.
On 28 February the foreign debtor would be worth FC2 000 x LC7 = LC14 000.
On 31 March the foreign debtor would be worth FC2 000 x LC6 = LC12 000.

B.
Between 31 January and 28 February, an exchange difference (gain) of LC6 000 arises:
[LC14 000-LC8 000].
Between 28 February and 31 March, an exchange difference (loss) of LC2 000 arises:
[LC12 000-LC14 000].
In total, between 31 January and 31 March, a net exchange difference (net gain) of LC4 000 arises:
[LC12 000-LC8 000].

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C.
Journals:
Debit Credit
31 January
Foreign debtor 8 000
Sales 8 000
Sold goods to foreign customer
28 February
Foreign exchange gain 6 000
Translating foreign debtor
31 March
Foreign exchange loss 2 000

Notice how the amount of sales income recognised is unaffected by changes in the exchange rates.

2.5.3 Subsequent measurement: non-monetary items

Non-monetary items include assets such as:
• property, plant and equipment;
• intangible assets; and
• inventories.

Foreign currency can affect non-monetary items in two basic ways:
• Local currency denominated non-monetary items:
They could have been purchased using foreign currency, in which case they are converted
into the local currency at the spot rate on transaction date, and are thereafter denominated
in the local currency (called the functional currency)
• Foreign currency denominated non-monetary items:
They could be owned by a foreign branch or foreign operation of the entity (the latter
would require consolidation into the books of the entity), in which case they are
denominated in foreign currency in the books of the branch (these will have to be
converted into the local currency).

Non-monetary items that:
• are measured at historical cost in a foreign currency are translated using the exchange rate
on transaction date;
• are measured at a value other than historical cost (e.g. fair value or recoverable amount)
in a foreign currency are translated using the exchange rate when the fair value was
determined.

The subsequent measurement of local currency denominated non-monetary items occurs
simply in terms of the relevant IFRS. These items are not affected by subsequent changes in
exchange rates. For example, if an item of plant is purchased where the purchase was
denominated in a foreign currency, this is converted into the local currency on transaction
date and the plant is then measured in terms of IAS 16 Property, plant and equipment.

The subsequent measurement of foreign currency denominated non-monetary items, whilst
measured in terms of the relevant IFRS, may be affected by a change in an exchange rate.
This occurs when the measurement of the item depends on the comparison of two or more
amounts. Typical examples are plant, where the measurement at year-end depends on a
comparison of the carrying amount with the recoverable amount. Another example includes
inventory, where the measurement at year-end depends on a comparison of the cost with the
net realisable value.
The reason that an exchange rate can affect such items is because:

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• the cost or carrying amount, as appropriate, is translated at the spot rate when the amount
was determined (e.g. on transaction date); and
• the net realisable value or recoverable amount, as appropriate, is translated at the spot rate
on the date that this amount is calculated (e.g. on reporting date).

Example 4: non-monetary item: measurement of plant bought from a foreign supplier

On 1 January 20X1, a South African company bought plant from an American company for
$100 000. The South African company settled the debt on 31 March 20X1.
Spot rates
Date (Rand: Dollar)
1 January 20X1 R6.0: $1
31 March 20X1 R6.3: $1
31 December 20X1 R6.5: $1
31 December 20X2 R6.2: $1

The plant is depreciated to a nil residual value over 5 years using the straight-line method.
The recoverable amount was calculated on 31 December 20X2: R320 000.

Required:
Show all journal entries relating to plant for the years ended 31 December 20X1 and 20X2 in
the books of the South African entity.

Solution to example 4: non-monetary item: journals

1 January 20X1 Debit Credit
Plant: cost $100 000 x R6 600 000
Foreign creditor 600 000
Purchased plant from a foreign supplier (translated at spot rate)

31 March 20X1
Foreign exchange loss $100 000 x R6.30 – R600 000 30 000
Foreign creditor 30 000
Translating foreign creditor on settlement date (at latest spot rate)

Foreign creditor $100 000 x R6.30 630 000
Bank 630 000
Payment of foreign creditor

31 December 20X1
Depreciation (R600 000 – 0) / 5 years 120 000
Plant: accumulated depreciation 120 000
Depreciation of plant

31 December 20X2
Depreciation (R600 000 – 0) / 5 years 120 000

Impairment loss CA: 600 000 –120 000 –120 000 40 000
Plant: accumulated impairment loss – Recoverable amount: 320 000 40 000

Notice how the measurement of the non-monetary asset (plant) is not affected by the changes in the
exchange rates. This is because it is a local currency denominated item.

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Example 5: non-monetary item: measurement of inventory owned by foreign branch

A South African company (local currency: Rands: R) has a branch in Britain (local currency:
Pound: £). On 1 January 20X1, the branch in Britain bought inventory from a British supplier
for £100 000 in cash.
Spot rates
Date (Rand: Pound)
1 January 20X1 R10.0: £1
31 December 20X1 R12.0: £1

The inventory is still in stock and its net realisable value is estimated to be £90 000 at
31 December 20X1.

Required:
Show all journal entries for the years ended 31 December 20X1:
A. in the books of the British branch; and
B. in the books of the South African entity.

Solution to example 5A: inventory: journals in the books of a foreign branch

Journals in the foreign branch: denominated in Pounds
Debit Credit
1 January 20X1
Inventory Given: £100 000 100 000
Bank 100 000
Purchased inventory from a local supplier (British)

31 December 20X1
Inventory write-down £100 000 – £90 000 10 000
Inventory 10 000
Inventory written down to lower of cost or net realisable value

Notice how, in the branch’s books, the inventory is written down since the net realisable value in
Pounds is less than the carrying amount in Pounds.

Solution to example 5B: inventory: journals in the books of the local entity

Journals in the local entity: denominated in Rands
Debit Credit
1 January 20X1
Inventory £100 000 x R10 1 000 000
Bank 1 000 000
Purchased inventory from a foreign supplier (translated at spot rate)

Notice how there is no write-down of inventory in the SA entity’s books because the net realisable
value is measured using the spot rate on the date at which the recoverable amount is calculated (R12:
£1) and the cost is measured using the spot rate on transaction date (R10: £1). The fact that the British
branch recognises a write-down whyereas the South African books does not, is purely as a result of the
change to the exchange rates!
Pounds Rands
Cost: 31/12/20X1 Pounds: £100 000 100 000 1 000 000
Rands: £100 000 x R10
Net realisable value: 31/12/20X1 Pounds: £90 000 90 000 1 080 000
Rands: £90 000 x R12
Write-down 10 000 N/A

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Example 6: non-monetary item: measurement of plant owned by foreign branch
A South African company (local currency: Rands: R) has a branch in Britain (local currency:
Pound: £). On 1 January 20X1, the branch in Britain bought a plant for £100 000 in cash.
Spot rates
Date (Rand: Pound)
1 January 20X1 R12.0: £1
31 December 20X1 R10.7: £1
31 December 20X2 R10.0: £1
The plant is depreciated to a nil residual value over 5 years using the straight-line method.
The recoverable amount was calculated on 31 December 20X2: £70 000.
Required:
Show all journal entries for the years ended 31 December 20X1 and 31 December 20X2:
A. in the books of the British branch; and
B. in the books of the South African entity.

Solution to example 6A: plant: journals in the books of the foreign branch
Journals in the books of the foreign branch: denominated in Pounds
Debit Credit
1 January 20X1
Plant: cost Given: £100 000 100 000
Bank 100 000
Purchased plant
31 December 20X1
Depreciation (£100 000 – 0) / 5 years 20 000
31 December 20X2
Depreciation (£100 000 – 0) / 5 years 20 000
Notice how, in the branch’s books, the asset is not considered to be impaired, since the recoverable
amount in Pounds (£70 000) is greater than the carrying amount in Pounds (£100 000 – 20 000 –
20 000). Notice that there are obviously no exchange differences in this example since the purchase in
Pounds is recorded in Pounds in the books of the British branch.

Solution to example 6B: plant: journals in the books of the local entity
Journals in the books of the local entity: denominated in Rands
Debit Credit
1 January 20X1
Plant: cost £100 000 x R12 1 200 000
Bank 1 200 000
Purchased plant from a foreign supplier (translated at spot rate)
31 December 20X1
Depreciation (1 200 000 – 0) / 5 years 240 000
31 December 20X2
Depreciation (1 200 000 – 0) / 5 years 240 000
Impairment loss CA: 1 200 000 – 240 000 – 240 000 – 20 000
Plant: accumulated imp loss Recoverable amount: £70 000 x R10 20 000
Impairment of plant (CA measured at spot rate on transaction date; RA
measured at spot rate at year-end)

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Notice how the South African entity reflects an impairment on the plant despite the fact that, in Pound
terms, the plant is not impaired! This is because of the change in the exchange rate.
• the recoverable amount in the SA entity’s books is measured using the spot rate on the date at
which the recoverable amount is calculated (R10: £1); whereas
• the cost and related accumulated depreciation is measured using the spot rate on transaction date
(R12: £1).
Thus the change in exchange rate causes a South African impairment loss despite the fact that the
British branch does not recognise an impairment loss!
Pounds Rands
Carrying amount: 31/12/20X2 Pounds: £100 000 x 3 / 5 yrs 60 000 720 000
Rands: £100 000 x 3 / 5 yrs x R12
Recoverable amount: 31/12/20X2 Pounds: £70 000 70 000 700 000
Rands: £70 000 x R10
Impairment N/A 20 000

2.6 Exchange differences on monetary items

It should now be quite clear that fluctuating currency exchange rates will therefore have an
effect on all monetary items that are denominated in a foreign currency, including:
• sales to a foreign customer (export) on credit;
• purchases from a foreign supplier (import) on credit;
• loans made to a foreign borrower; and
• loans raised from a foreign lender.

Although the basic principles apply to import, export and loan transactions, loan transactions
have an added complexity, being the interest accrual. Let us therefore first look at the
journals involving exports and imports and then let us look at loan transactions.

2.6.1 Import and export transactions

2.6.1.1 Transaction and settlement on the same day (cash transaction)

If the date on which the transaction is journalised (transaction date) is the same date on which
cash changes hands in settlement of the transaction (settlement date), then there would
obviously be no exchange differences to account for.

Example 7: import transaction - settled on same day (cash transaction)

A company in Botswana purchased inventory for £100 from a company in Britain on
5 March 20X1, the transaction date.
The purchase price was paid on this same day, when the spot rate was P3: £1.
The local currency (functional currency) in Botswana is the Pula (P).
The local currency (functional currency) in Britain is the Pound (£).

Required:
Show the journal entry/ies in the books of the company in Botswana.

Solution to example 7: import transaction - settled on same day
Debit Credit
5 March 20X1
Inventory 300
Bank 300
Purchase of inventory: £100 x 3 = P300

No exchange differences are possible since there is no balance payable that would need translation.

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Example 8: export transaction - settled on same day (cash transaction)

A company in the United Kingdom sold inventory for P1 200 to a company in Botswana on
17 May 20X5, the transaction date.
The sale proceeds were received on the same day when the spot rate was P4: £1.
The cost of the inventory to the UK company was £150.
The local currency (functional currency) in Botswana is the Pula (P).
The local currency (functional currency) in the United Kingdom is the Pound (£).

Required:
Show the journal entries in the books of the company in the United Kingdom.

Solution to example 8: export transaction - settled on same day

17 May 20X5 Debit Credit
Bank 300
Sales 300
Sale of inventory for cash: P1200 / 4 = £300
Cost of sales 150
Inventory 150
Recording cost of the inventory sold: amount given

2.6.1.2 Settlement deferred (credit transactions)

Exchange differences arise when the settlement date occurs after transaction date. The initial
transaction (e.g. asset acquired, expense incurred or sale earned) is recorded at the spot rate
on the transaction date and remains unaffected by movements in the exchange rates. Any
movement in the exchange rate after transaction date relating to the amount outstanding
(payable or receivable) is recorded as a foreign exchange gain (income) or foreign exchange
loss (expense).

2.6.1.2.1 Settlement of a credit transaction before year-end

When the settlement of a credit transaction occurs before year-end:
• record the initial transaction at spot rate on transaction date;
• convert the outstanding balance (owing or receivable) to the spot rate on settlement date;
• record the payment (made or received).

Example 9: import - credit transaction settled before year-end

5 March 20X1, the transaction date. The purchase price was paid on 5 April 20X1. The year-
end of the company in Botswana is 30 April 20X1.
Spot rates
Date (Pula: Pound)
5 March 20X1 P3: £1
5 April 20X1 P4: £1
Required:

Solution to example 9: import - credit transaction settled before year-end
5 March 20X1 Debit Credit
Inventory 300
Foreign creditor 300
Purchase of inventory on credit: £100 x 3 = P300

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5 April 20X1 Debit Credit
Foreign exchange loss 100
Translation of creditor to spot rate on settlement date: (£100 x 4) -
300 = P100
Bank 400
Payment of creditor at spot rate on settlement date: £100 x 4 = P400
Notice that since the £ became more expensive (£1 cost P3 on transaction date but cost P4 on date of
settlement), the Botswana company made a loss of P100 by not paying for the inventory on date of
acquisition (transaction date). The cost of the inventory, however, remains unaffected since this is a
non-monetary item!

Example 10: export - credit transaction settled before year-end

17 May 20X5, the transaction date. The inventory was paid for on 13 June 20X5.
The inventory cost the UK company £150.
The year-end of the company in the United Kingdom is 30 September.

Relevant exchange rates are:
Spot rates
Date (Pound: Pula)
17 May 20X5 £1: P4
13 June 20X5 £1: P3
Required:

Solution to example 10: export - credit transaction settled before year-end

Foreign debtor 300
Sales 300
Sale of inventory: P1 200 / 4 = £300

31 March 20X5
Cost of sales 150
Inventory 150
Recording cost of sale of inventory: Cost = £150 (given)

13 June 20X5
Foreign debtor 100
Foreign exchange gain 100
Translating debtor at settlement date: P1 200 / 3 – 300
Bank 400
Foreign debtor 400
Amount received from foreign debtor: P1 200 / 3

2.6.1.2.2 Settlement of a credit transaction after year-end

When the settlement of a credit transaction occurs after year-end:
• record the initial transaction at spot rate on transaction date;
• translate the outstanding balances (owing or receivable) to the spot rate on translation
date (year-end);
• convert the outstanding balances (owing or receivable) to the spot rate on settlement date;
• record the payment (made or received).

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Example 11: import - credit transaction settled after year-end

5 March 20X1, the transaction date. The purchase price was paid on 5 April 20X1. The year
end of the company in Botswana is 31 March.
Spot rates
Date (Pound: Pula)
5 March 20X1 £1: P3
31 March 20X1 £1: P3.70
5 April 20X1 £1: P4
Required:

Solution to example 11: import - credit transaction settled after year-end

Debit Credit
5 March 20X1
Inventory £100 x 3 = P300 300
Purchase of inventory on credit
Foreign exchange loss (£100 x 3.7) – 300 = P70 70
Foreign creditor 70
Translation of creditor to spot rate at year-end

5 April 20X1
Foreign exchange loss (£100 x 4) – (300 + 70) = P30 30
Foreign creditor 30
Conversion of creditor to spot rate on settlement date
Foreign creditor £100 x 4 = P400 400
Bank 400
Payment of creditor at spot rate on settlement date

Notice that since the £ became more expensive (£1 cost P3 on transaction date but cost P4 on date of
settlement), the Botswana company made a loss of P100 by not paying for the inventory on the date of
acquisition (transaction date). This loss is recognised partially in the year ended 31 March 20X1
(P70) and partially in the year ended 31 March 20X2 (P30).
The cost of inventory remained unaffected because this is a non-monetary item!

Example 12: export - credit transaction settled after year-end

17 May 20X5, the transaction date. The sale proceeds were received on 13 June 20X5.
The cost of the inventory to the UK company was £150.
The UK company has a 31 May financial year-end.
Spot rates
Date (Pound: Pula)
17 May 20X5 £1: P4
31 May 20X5 £1: P3.4
13 June 20X5 £1: P3
Required:

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Solution to example 12: export - credit transaction settled after year-end

Foreign debtor P1200 / 4 = £300 300
Sales 300
Sale of inventory
Cost of sales Cost = £150 (given) 150
Inventory 150
Recording the cost of the inventory sold
31 May 20X5
Foreign debtor P1200 / £3.4 = £353 - 300 53
Translating the foreign debtor at year-end
13 June 20X5
Foreign debtor P1200 / £3 = 400 – (300 + 53) = £47 47
Translating foreign debtor at settlement date
Bank P1200 / £3 400
Foreign debtor 400
Proceeds received from foreign debtor
Notice how the sales figure of 300 remains unaffected by changes in the exchange rate. This is
because sales is a non-monetary item (you may want to read the definition of monetary items).

Example 13: import – credit transaction – another example

A company in the United Kingdom ordered inventory to the value of $900 from an American
company on 16 January 20X1. The transaction date is 5 February 20X1.
The year-end is 31 March 20X1. The relevant exchange rates are as follows:
Spot rates
Date (Pound: dollar)
16 January 20X1 £1: $2.2
5 February 20X1 £1: $2.5
31 March 20X1 £1: $2.25
5 April 20X1 £1: $3.0
Required:
Show all journal entries and show the balances in the trial balance of the UK company as at
31 March 20X1 assuming that the UK company paid the American company on:
A. 5 February 20X1 (on transaction date; i.e. before year-end).
B. 31 March 20X1 (at year-end).
C. 5 April 20X1 (after year-end).

Solution to example 13A: import – credit transaction – payment before year-end
Journals:

5 February 20X1 Debit Credit
Inventory $900 / £2.5 360
Bank 360
Purchase of inventory: exchange rate £1: $2.5

Trial balance as at 31 March 20X1 (extracts)
Debit Credit
Inventory 360
Creditor 0

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Solution to example 13B: import – credit transaction – payment at year-end

Journals:
Inventory $900 / £2.5 360

31 March 20X1
Foreign exchange loss (expense) $900 / 2.25 – 360 40
Foreign creditor 40
Translation of foreign creditor before payment
Foreign creditor $900 / 2.25 = 400 400
Bank 400
Payment of foreign creditor:

Trial Balance
As at 31 March 20X1 (extracts)
Debit Credit
Inventory 360
Foreign creditor 0
Foreign exchange loss (expense) 40

Solution to example 13C: import – credit transaction – payment after year-end

Journals:
Inventory $900 / £2.5 360

31 March 20X1
Foreign exchange loss (expense) $900 / 2.25 – 360 40
Foreign creditor 40
Translation of foreign creditor at year-end

5 April 20X1
Foreign creditor $900/ 3 – (360 + 40) 100
Foreign exchange gain (income) 100
Translation of the foreign creditor before payment
Foreign creditor $900/ 3 300
Bank 300
Payment of foreign creditor

Trial Balance
As at 31 March 20X1 (extracts)
Debit Credit
Inventory 360
Foreign exchange loss (expense) 40
Notice that there is no exchange gain or loss when the amount is paid on transaction date (part A).
Contrast this with:
• part B where the foreign exchange loss recognised to payment date is 40; and
• part C where a foreign exchange loss of 40 is recognised in 20X1 and a foreign exchange gain of
100 is recognised in 20X2 (i.e. a net foreign exchange gain of 100 – 40 = 60 on this transaction).
In all 3 scenarios, the value of the inventory remains at £360 because this is a non-monetary item.

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2.6.2 Foreign loans

The third type of possible transactions is the granting of loans to foreign entities or the receipt
of a loan from a foreign lender.

Interest receivable (on loans made) or interest payable (on loans received) must be calculated
based on the outstanding foreign currency amount and then translated into the local currency
at the average rate over the period that the interest was earned.

The easiest way to do this correctly is:
• calculate the loan amortisation table in the foreign currency;
• journalise the payment at the spot rate;
• journalise the interest at the average rate; and
• calculate the difference between the carrying amount of the loan and the value of the
balance owing at spot rate at year end.

This is best explained by way of an example:

Example 14: foreign loans

Brix ’n Stones Limited, a South African brick laying conglomerate, obtained a long term loan
from Gill Bates, living in the Cayman Islands. The terms of the loan were as follows:
• Gill transfers EUR100 000 into Brix ’n Stones Limited’s bank account on
1 January 20X4.
• The interest rate on the loan was 7,931% p.a.
• Brix ‘n Stones is required to make repayments on the loan of EUR25 000 annually, with
the first payment falling due on 31 December 20X4.

Brix ’n Stones Limited has the ZAR (South African Rand) as its functional currency. The
currency used in the Cayman Islands is the EUR (Euro). Brix ‘n Stones Limited has a 31
December financial year-end.
Date Spot rates Average rates
1 January 20X4 EUR1: ZAR8
31 December 20X4 EUR1: ZAR8.5
31 December 20X5 EUR1: ZAR7.5
20X4 EUR1: ZAR8.20
20X5 EUR1: ZAR7.70
Required:
Show the journal entries required to record the above loan transaction in Brix ’n Stones
Limited’s accounting records for the years ended 31 December 20X4 and 31 December 20X5.

Solution to example 14: foreign loans

Journals:
Debit Credit
1 January 20X4
Bank 100 000 x 8 800 000
Long-term loan 800 000
Proceeds received on the foreign loan raised from Cayman Islands

31 December 20X4
Finance cost 7 931 (W1) x 8.2 = 213 200 65 034
Interest expense on the foreign loan (converted at average rates)

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31 December 20X4 continued … Debit Credit
Long-term loan 25 000 x 8.5 212 500
Bank 212 500
Payment of instalment on loan: (at spot rate on pmt date)
Foreign exchange loss 82 931 (W1) x 8.5 – balance so far: 52 380
Long-term loan (800 000 + 65 034 – 212 500) 52 380
Translating foreign loan at year end (at spot rate at year-end)

31 December 20X5
Finance cost 6 577 (W1) x 7.70 50 643
Interest expense raised on loan (converted at average rates)
Long-term loan 25 000 x 7.5 187 500
Bank 187 500
Payment of instalment on loan: (at spot rate on pmt date)
Long-term loan 64 508 (W1) x 7.5 – balance so far: 84 247
Foreign exchange gain (82 931 x 8.5 + 50 643 – 187 500) 84 247
Translating foreign loan at year end (at spot rate at year-end)

Working 1: Effective interest rate table in foreign currency: Euros

Date Interest Payments Balance
7,931%
100 000
20X4 7 931 (25 000) 82 931
20X5 6 577 (25 000) 64 508
20X6 5 116 (25 000) 44 624
20X7 3 539 (25 000) 23 163
20X8 1 837 (25 000) 0
25 000 (125 000)

3. Presentation and functional currencies

3.1 General

IAS 21 allows an entity to present its financial statements in whichever currency it chooses to,
this is then known as the presentation currency. However, IAS 21 requires that an entity’s
transactions and balances be measured in that entity’s functional currency. Thus entities must
establish their functional currencies. It is possible for an entity’s functional and presentation
currency to be the same currency, but where it is not the same, a translation reserve will
result.

3.2 Determining the functional currency

A functional currency is defined as the currency of the primary economic environment in
which the entity operates. The primary economic environment in which an entity operates is
usually taken to be the environment in which it primarily generates and expends cash.

In establishing its functional currency, an entity should consider (extracts from IAS 21):
• the currency that mainly influences the sales prices for goods and services (this will often
be the currency in which prices for its goods and services are denominated and settled);
• the currency of the country whose competitive forces and regulations mainly determine
the sales prices of its goods and services;

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• the currency that mainly influences labour, material and other costs of providing goods or
services (this will often be the currency in which such costs are denominated and settled);
• the currency in which funds from financing activities (i.e. issuing debt and equity
instruments) are generated; and
• the currency in which receipts from operating activities are usually retained.

As these factors usually do not change often, once a functional currency is determined it is not
changed unless an entity’s circumstances have changed so significantly that the above factors
would result in a different functional currency being more appropriate.

3.3 Accounting for a change in functional currency

An entity may not change its functional currency unless there is a change in the underlying
transactions and conditions that result in changes to the factors discussed in 3.2 above.

Should there be a change in functional currency, it must be accounted for prospectively from
the date of change of functional currency.

Accounting for such a change is relatively simple. All items are translated into the functional
currency using the spot exchange rate available at the date of change. For non-monetary
items, the new translated amount shall now be considered to be their historical cost.

3.4 Using a presentation currency other than the functional currency

As stated before, an entity may choose to present its financial statements in a currency of its
choice. That currency is then known as the presentation currency. Should an entity choose to
disclose financial statements in a currency other than its functional currency, it will have to
translate all of its items from the functional to the presentation currency at year end.

The following procedure is used to translate an entity’s trial balance into a presentation
currency different to its functional currency:
• all assets and liabilities (including comparative amounts) shall be translated into the
presentation currency using the closing rate available at the reporting date;
• all incomes and expenses shall be translated at the spot rate available at the dates of the
various transactions (for practical purposes, it is often acceptable to use the average rate
for the presentation period, provided the currency did not fluctuate too much); and
• all resulting exchange differences are recognised in other comprehensive income (the
account in which these exchange differences are accumulated is often referred to as the
foreign currency translation reserve).

3.4.1 Explanation of the foreign currency translation reserve

Exchange differences arise upon translation because:
• assets and liabilities are translated at one rate, while movements in those assets and
liabilities (represented by incomes and expenses) are translated at a different rate; and
• opening balances of net assets are translated at a rate different to the previous closing rate.

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Example 15: foreign currency translation reserve

Sticky Fingers Limited, a sweet manufacturer in Never-never Land, has a functional currency
of Chocca’s (C). It has decided to present its financial statements in the currency of Faraway
Land, (an island nearby), as most of its shareholders reside on this island. Faraway Land’s
currency is the Flipper (F). The following exchange rates are available:
Dates Exchange Rates
20X5 1chocca: 6.5 flippers Average rate
31 December 20X5 1chocca: 7 flippers Spot rate

Trial balance of Sticky Fingers Ltd at 31 December 20X5 Debit Credit
Accounts payable 294 600
Accounts receivable 155 000
Bank 300 000
Land & buildings 944 300
Property, plant & equipment 600 000
Investments – at fair value 120 000
Ordinary share capital 403 300
General reserve 680 900
Sales 1 509 500
Cost of sales 733 200
Operating expenses 407 000
Taxation 439 300
3 698 800 3 698 800
Required:
Translate the above trial balance into the presentation currency using the method required by
IAS 21.

Solution to example 15: foreign currency translation reserve

Account Working Debit Credit
Accounts payable 294 600 x 7 2 062 200
Accounts receivable 155 000 x 7 1 085 000
Bank 300 000 x 7 2 100 000
Land & buildings 944 300 x 7 6 610 100
Property, plant & equipment 600 000 x 7 4 200 000
Investments – at fair value 120 000 x 7 840 000
Ordinary share capital 403 300 x 7 2 823 100
General reserve 680 900 x 7 4 766 300
Long-term loan 810 500 x 7 5 673 500
Sales 1 509 500 x 6.5 9 811 750
Cost of sales 733 200 x 6.5 4 765 800
Operating expenses 407 000 x 6.5 2 645 500
Taxation 439 300 x 6.5 2 855 450
Foreign currency translation reserve Balancing figure 35 000
25 136 850 25 136 850

If the foreign currency translation reserve relates to a foreign operation and if this foreign
operation is subsequently disposed of, the reserve would be reclassified from other
comprehensive income (where the exchange differences are accumulated as a separate
component of equity) to profit or loss, and disclosed as a reclassification adjustment.

Since this textbook does not cover consolidations, foreign operations is not covered further in
this chapter.

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4. Presentation and disclosure

The following disclosures are required by IAS 21:
• the amount of the exchange differences recognised in profit and loss except for those
arising on financial instruments measured at fair value through profit or loss;

• the net exchange difference recognised in other comprehensive income and accumulated
in a separate component of equity, reconciling the amount of such exchange differences at
the beginning and end of the period.

• if there is a change in the functional currency, state this fact and the reason for the change
in functional currency.

• where the presentation currency differs from the functional currency,
- state the functional currency and the reason for using a different presentation
currency;
- it shall describe the financial statements as complying with the IFRSs only if they
comply with all the requirements of each applicable IFRS including the method
required for translating functional currency items to presentation currency amounts.

• when an entity displays its financial statements or other financial information in a
currency that is different from either its functional currency or its presentation currency
and the IFRS requirements (referred to in the above bullet) are not all met, it shall:
- clearly identify the information as supplementary information to distinguish it from
the information that complies with IFRSs;
- disclose the currency in which the supplementary information is displayed;
- disclose the entity’s functional currency and the method of translation used to
determine the supplementary information.

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5. Summary

Foreign currency transactions

Functional currency Exchange rates Dates

• Of the primary • Two formats: • Transaction date
economic environment • How much LC must • Reporting date
• Currency in which all be paid for 1 unit • Settlement date
transactions and of FC; or
balances must be • How much FC can
measured be bought for 1
unit of LC

Recognition
In profit and loss

Measurement

Initial Subsequent
• spot rate on transaction date • Monetary:
Spot rate on translation dates:
settlement/ reporting dates
• Non-monetary
Historical cost:
Spot rate on transaction date
Other value:
Spot rate on date that other value
was determined

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