IAS 21: The Effect of changes in Foreign Exchange Rates
Objective of IAS 21: Prescribes how to include foreign currency transactions and foreign operations in
the financial statements of an entity and how to translate financial statements into a presentation
currency.
Two types of foreign activities:
Foreign currency transactions
Foreign operations
Two main accounting issues:
Which exchange rates to use; and
How to report the effects of changes in exchange rates in the financial statements
Functional Currency
currency of primary economic environment
operations are carried out in functional currency
Change in Functional Currency:
o Accounted for prospectively. The entity shall translate all items into the new functional
currency using the exchange rate at the date of the change.
Presentation Currency
financial statements are prepared in presentation currency
FOREIGN CURRENCY TRANSACTIONS
Initial Recognition: Spot Exchange Rate at the date of Transaction
Subsequent Measurement: Monetary Items – Closing Rate
Non-Monetary Items – Historical Cost in a foreign currency be
translated at the date of transaction
Non-Monetary Items measured at FV – exchange rate at the date the
fair value was determined
Definition of Terms:
Exchange Rate – is the ratio of exchange for two currencies
Direct Quote – how much local currency must be exchanged to receive one foreign
currency
Indirect Quote – how much of a foreign currency must be exchanged to receive one unit
of local currency
Spot Exchange Rate – is the exchange rate for immediate delivery
Closing Rate – is the spot exchange rate at the end of the period
Recognition of Exchange Differences:
Exchange Differences from Monetary Items are recognized in Profit or Loss.
FOREIGN OPERATION
Goal: translate foreign currency items into its functional currency
Measurement (not hyperinflationary)
Assets and Liabilities – closing rate (the date of Statement of Financial Position)
Since all assets and liabilities are translated at closing rate, consequently, total equity is
automatically translated at historical rates. However, the individual components of equity are
translated as follows:
o Share Capital, Share Premium and all other components of Equity, except R/E,
translated at Historical Rate
o Dividends – translated at the historical rate
o Income and Expenses – spot exchange rates at the dates of the transactions. Average
Rates can also be used, if rates fluctuate significantly, using of average rate is
inappropriate.
Recognition of exchange differences:
The balancing figure after all the accounts are translated is recognized within equity particularly
in OCI.
IAS 29: Financial Reporting in Hyperinflationary Economies
If the functional currency is the currency of a hyperinflationary economy, the entity’s financial
statements are first restated using IAS 29 before they are translated into IAS 21.
Restatement Procedures:
Only Non-Monetary items not already stated at the measuring unit current as of end of reporting period
are restated. Monetary items are not restated.
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐏𝐫𝐢𝐜𝐞 𝐈𝐧𝐝𝐞𝐱,Index as of the end of Reporting period
Restated Value= Historical Cost x 𝐇𝐢𝐬𝐭𝐨𝐫𝐢𝐜𝐚𝐥 𝐏𝐫𝐢𝐜𝐞 𝐈𝐧𝐝𝐞𝐱,Index as of the Acquisition Date
Indication of Hyperinflation:
The Standard does not establish an absolute rate at which hyperinflation is deemed to arise - but allows
judgement as to when restatement of financial statements becomes necessary. Characteristics of the
economic environment of a country which indicate the existence of hyperinflation include: [IAS 29.3]
the general population prefers to keep its wealth in non-monetary assets or in a relatively stable
foreign currency. Amounts of local currency held are immediately invested to maintain
purchasing power;
the general population regards monetary amounts not in terms of the local currency but in
terms of a relatively stable foreign currency. Prices may be quoted in that currency;
sales and purchases on credit take place at prices that compensate for the expected loss of
purchasing power during the credit period, even if the period is short;
interest rates, wages, and prices are linked to a price index; and
the cumulative inflation rate over three years approaches, or exceeds, 100%.
Recognition of Exchange Differences:
A gain or loss on the net monetary position is included in net income.
Derivatives and Hedging Transactions
Derivatives – is a financial instrument or other contract that derives its value from the changes in value
of some other underlying asset or other instrument
Characteristics of Derivatives
Its value changes in response to change in an underlying
Requires no initial investment or a very minimal initial net investment
It is settled at a future date
Purposes of Derivatives
To speculate (incur risk); or
To hedge (avoid or manage risk).
Underlying – Is a specified variable (interest rate, forex rate, price etc.) that may or may not occur
Notional Amount – is a specified unit of measure (currency, units, shares, bushels, pounds, etc.)
Common types of Derivatives
Forward Contract – to buy or sell a commodity, security or foreign currency at a specified
amount or quantity, at a specified future time and at a price which is agreed now.
Futures Contract – is a contract traded on an exchange that allows an entity to buy or sell a
commodity, security or foreign currency at a specified amount or quantity, at a specified future
time and at a price which is agreed now.
Option – is a contract giving the holder the right, but not the obligation, to buy or sell an asset at
a specified price any time during a specified period in the future. The option buyer will exercise
the option only when the option is in the money, that is, the buyer gains in exercising the
option.
o Call Option – an option to buy
o Put Option – an option to sell
Exercise of option:
At the money – holder may or may not exercise the option. No gain or
loss.
In the money – holder should exercise. Gain in exercising.
Out of the money – holder should not exercise. Loss in exercising.
Swap – is a contract in which two parties agree to exchange payments in the future based on
the movement of some agreed-upon price or rate.
o Interest Rate Swap – exchange of future interest payments
o Foreign Currency Swap – exchange sum of money in one currency for another currency
Measurement of Derivatives
Initial Measurement: (No initial investment). Most derivatives are not recorded at the date of
initial transaction, unless an amount is paid for the derivatives.
Subsequent Measurement: The value or settlement amount of derivative (notional amount x
underlying)
All Derivatives are measured at fair value. The accounting for fair value changes depends on whether the
derivative is:
Not designated as a hedging instrument
o Considered as speculation. These are accounted as held for trading securities. FV
changes are recognized in P/L.
Designated as fair value hedge
Designated as cash flow hedge
Hedging – designating one or more hedging instruments so that their change in fair values or cash flows
offset, in whole or in part, the change in the fair value or cash flows of the hedge item.
Hedging Instrument – a designated derivative or a designated non-derivative financial asset or
financial liability whose fair value or cash flows are expected to offset changes in the fair value
or cash flows of a designated hedged item.
Hedged Item – an asset, liability, firm commitment, highly probable forecast transaction, or net
investment in foreign corporation
Note: Only items or transactions that involve external parties can be designated as
hedged items. Those that involve related parties are eliminated in the Consolidated FS,
but may be presented in separate FS.
Hedging Relationships:
Fair Value Hedge – a hedge of exposure to changes in fair value of a recognized asset or liability
or an unrecognized firm commitment that is attributable to a particular risk and could affect
profit or loss.
o The gain or loss from remeasuring the hedging instrument at fair value should be
recognized in profit or loss; and
o The gain or loss on the hedged item shall adjust the CA of the hedged item and
recognized in profit or loss. This applies even if the hedged item at cost.
Cash Flow Hedge – a hedge of the exposure to variability in cash flows that is attributable to a
particular risk associated with a recognized asset or liability or a highly probable forecast
transaction and could affect profit or loss
o The portion of the gain or loss on the hedging instrument that is determined to be
effective hedge shall be recognized in other comprehensive income; and
o The ineffective portion of the gain or loss on the hedging instrument shall be recognized
in profit or loss
Hedge of a net investment in a foreign operation
o The portion of the gain or loss on the hedging instrument that is determined to be
effective hedge shall be recognized in other comprehensive income; and
o The ineffective portion of the gain or loss on the hedging instrument shall be recognized
in profit or loss
