The effects of changes in
foreign exchange rates
IAS – 21
IAS 21 The effects of changes in foreign
exchange rates
IAS 21 deals with:
◦ the definition of functional and presentation currencies
◦ accounting for individual transactions in a foreign currency
◦ translating the financial statements of a foreign operation.
The two main accounting issues
Transactions and assets and liabilities in foreign currencies are translated or converted from
the foreign currency into the currency of the reporting entity. The process of translation
would be quite simple if exchange rates between currencies remained fixed. However,
exchange rates are continually changing. The translated valuation of foreign currency assets
or liabilities in the statement of financial position might therefore change if they are
translated at different times.
The two main accounting issues when accounting for foreign currency items are:
◦ What exchange rate(s) should be used for translation?
◦ How to account for the gains or losses that arise when exchange rates change?
Terms and definitions used in IAS 21:
currency definitions
Presentation currency
◦ The currency in which the financial statements of an entity are presented
Functional currency
◦ The currency of the primary economic environment in which an entity operates.
Foreign currency
◦ A currency other than the functional currency of the entity
Terms and definitions used in IAS 21:
other definitions
Exchange rate
◦ The rate of exchange between two currencies
Spot rate
◦ The exchange rate at the date of the transaction
Closing rate
◦ The spot exchange rate at the end of the reporting period
Monetary and Non-monetary items
Monetary items
◦ Units of currency held, or assets and liabilities to be received or paid (in cash), in a fixed number of
currency units. Examples of monetary items include cash itself, loans, trade payables, trade
receivables and interest payable.
Non-monetary items
◦ Non-monetary items are not defined by IAS 21, but they are items that are not monetary items.
They include tangible non-current assets, investments in other companies, investment properties
and deferred taxation (which is a notional amount of tax rather than an actual amount of tax
payable.)
Determining an entity's functional currency
An entity considers the following factors in determining its functional currency (IAS 21: para.
9):
a) The currency:
i. That mainly influences sales prices for goods and services (this will often be the currency in
which sales prices for its goods and services are denominated and settled); and
ii. Of the country whose competitive forces and regulations mainly determine the sales prices
of its goods and services.
b) 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 following factors may also provide evidence of an entity's functional currency (IAS 21:
para. 10):
a) The currency in which funds from financing activities are generated
b) The currency in which receipts from operating activities are usually retained.
Test your understanding
Chive is an entity located in a country whose currency is dollars ($).
Seventy per cent of Chive’s sales are denominated in dollars and 30% of them are
denominated in sterling (£). Chive does not convert receipts from customers into other
currencies. Chive buys most of its inventories, and pays for a large proportion of operating
costs, in sterling.
Chive has two bank loans outstanding. Both of these loans are denominated in dollars.
Required: What is the functional currency of Chive?
Solution
Firstly, the primary indicators of functional currency should be applied. Most of Chive’s sales
are denominated in dollars and so this would suggest that the dollar is its functional
currency. However, since a lot of the costs of the business are denominated in sterling, it
could be argued that its functional currency is sterling.
Since the primary indicators of functional currency are not clear cut, it is important to look at
the secondary indicators. Receipts are retained in both dollars and sterling. However, funding
is generated in the form of dollar loans, which further suggests that the dollar might be
Chive's functional currency.
All things considered, it would seem that the functional currency of Chive is dollars. This
means that any business transactions that are denominated in sterling must be translated
into dollars in order to record them.
Reporting foreign currency transactions
in the functional currency
Initial recognition
Translate each transaction by applying the spot exchange rate between the functional
currency and the foreign currency at the date of transaction. An average rate for a period
may be used as an approximation if rates do not fluctuate significantly (IAS 21: paras. 21–
22).
At the end of the reporting period At the end of the reporting period foreign currency
assets and liabilities are treated as follows (IAS 21: para. 23):
Monetary assets and liabilities Restated at the closing rate
Non-monetary assets measured in terms of Not restated (ie they remain at historical
historical cost (eg non-current assets) rate at the date of the original transaction)
Non-monetary assets measured at fair value Translated using the exchange rate at the
date when the fair value was measured
Recognition of exchange differences
Exchange differences are recognised in profit or loss for the period in which they arise.
However, if fair value changes for a non-monetary asset measured at fair value are
recognised in other comprehensive income, eg property, plant and equipment held under
the revaluation model, the exchange difference component of the change in fair value is
also recognised in other comprehensive income, ie it need not be separated out (IAS 21:
para. 30).
Example – 1
An entity whose functional currency is the dollar ($) sold goods to a customer on credit for
100,000 antons on 1 November 20X1. The anton is a foreign currency. Exchanges rates
were:
◦ 1 November 20X1 $1 = 5.8 antons
◦ 31 December 20X1 $1 = 6.3 antons
◦ The entity's year end is 31 December 20X1.
Required Show the accounting treatment at the date of the transaction
and at the year end (to the nearest $).
Solution
At 1 November 20X1:
DEBIT Trade receivables (100,000/5.8) $17,241
CREDIT Revenue $17,241
At 31 December 20X1:
As it is a monetary item, the trade receivable must be retranslated to $15,873
(100,000/6.3).
An exchange loss is reported in profit or loss as follows:
DEBIT Profit or loss $1,368
CREDIT Trade receivables (17,241 – 15,873) $1,368
Example – 2
San Francisco, a company whose functional currency is the dollar, entered into the following
foreign currency transactions:
31.10.X8 Purchased goods on credit from Mexico SA for 129,000 Mexican pesos
31.12.X8 Payables have not yet been paid
31.1.X9 San Francisco paid its payables.
The exchange rates are as follows:
Pesos to $1
◦ 31.10.X8 9.5
◦ 31.12.X8 10
◦ 31.1.X9 9.7
Required
◦ How would these transactions be recorded in the books of San Francisco for the years ended 31
December 20X8 and 20X9?
Solution
Debit Credit
31.10.X8 Purchases (129,000 @ 9.50) 13,579
Payables 13,579
31.12.X8 Payables (Working) Profit or loss – 679
exchange gains 679
31.01.X9 Payables 12,900
Profit or loss – exchange losses Cash 399
(129,000 @ 9.7) 13299
Working: Exchange difference on payables
$
Payables as at 31.12.X8 (129,000 @10) 12,900
Payables as previously recorded 13,579
Exchange gain 679
Example & Solution
Olympic, which has a functional and presentation currency of the dollar ($), accounts for
land using the cost model in IAS 16 Property, Plant and Equipment. On 1 July 20X5, Olympic
purchased a plot of land in another country for 1.2 million dinars.
◦ Relevant exchange rates: Dinars to $1
◦ 1 July 20X5 4.0
◦ 30 June 20X6 3.0
Solution:
The land is initially recognised at cost. This should be translated into the functional currency
using the exchange rate on the purchase date. The land is therefore initially recorded at
$300,000 (1.2m dinars/4.0).
Land is not a monetary item so is therefore not retranslated. In accordance with IAS 16, no
depreciation is charged. This means that the land remains at $300,000.
Example – 3
Pallot, which has a functional and presentation currency of the dollar ($), accounts for land
using the revaluation model in IAS 16 Property, Plant and Equipment. On 1 July 20X5, Pallot
purchased a plot of land in another country for 1.2 million dinars. At 30 June 20X6, the fair
value of the plot of land was 1.5 million dinars.
◦ Relevant exchange rates: Dinars to $1
◦ 1 July 20X5 4.0
◦ 30 June 20X6 3.0
Solution
The land is initially recognised at cost. This should be translated into the functional currency
using the exchange rate on the purchase date. The land is therefore initially recorded at
$300,000 (1.2m dinars/4.0).
Land is not a monetary item so its cost is not retranslated. However, in accordance with the
revaluation model in IAS 16, a fair value has been determined. This valuation is in dinars and
so must be translated into the functional currency using the exchange rate in place when
the fair value was determined. This means that the land will must be revalued to $500,000
(1.5m dinars/3.0).
The increase in the carrying value of the land of $200,000 ($500,000 – $300,000) will be
reported as a revaluation gain in other comprehensive income for the year and a
revaluation reserve will be included within other components of equity on the statement of
financial position at the reporting date.
Determining a foreign operation's functional
currency
The following additional factors are considered in determining the functional currency of a
foreign operation, and whether its functional currency is the same as that of the reporting
entity (IAS 21: para. 11):
a) 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.
b) Whether transactions with the reporting entity are a high or a low proportion of the foreign
operation's activities.
c) 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.
d) 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.
