Midterm

• Highest score: 96 18

90%: 89
16
•
14

• UQ: 84 12

• Medium: 74 10

• LQ: 55 8

0
>=90 80-89 70-79 60-69 50-59 <50
Plan for the next few weeks...
Midterm exam paper review:
• Today, in my office 2:30-4:30pm (send me an email before you come, so I
can have your exam paper ready)
• After April 8, in TA’s office
April 4: No class (Ching Ming Festival)
April 11&18: finish up group reporting
• Finish up group reporting
• Final exam preparation
April 19-May 5: Questions via email
• Q&As (emails, office hours)
• Maybe a final review session
May 6: Final exam (cumulative)
ADVANCED FINANCIAL
ACCOUNTING STUDIES

Lecture 11
Foreign Currency Transactions
Group Reporting V

Angie Wang
School of Accountancy
Introduction
IAS 21 deals with foreign exchange issues associated with foreign investments.

Two key issues to be considered:

1. Translation of foreign subsidiary’s financial statements (i.e., foreign

operation translation)
2. Consolidating foreign subsidiaries (i.e., foreign subsidiary consolidation)
Introduction
How are exchange rates quoted?

Exchange rates are quoted in two ways:

- Direct quotation (1 unit of foreign currency : X unit of local/or domestic
currency)
- Indirect quotation (X unit of foreign currency : 1 unit of local currency)

To translate a direct quotation to an indirect quotation

- 1 unit of foreign currency/x unit of local currency

To translate an indirect quotation to a direct quotation

- 1 unit of local currency/x unit of foreign currency
Types of Foreign Exchange Exposures
Business entity is said to have foreign exchange (FX) exposure if changes in FX
rates affect its operating cash flow or items in its financial statements. Higher FX
exposure occurs in scenarios such as when:
―An entity that sells most of its products in overseas markets
―An entity that imports most of its inputs from other countries
―An entity that has foreign subsidiaries
―Foreign competitors operating in entity’s home market

Two types of FX rate exposures:

―Operating exposure
―Accounting exposure
Types of Foreign Exchange Exposures
 Operating exposure arises from strategic decision a firm makes about its input and output markets.
― Input markets: countries where firm incurs cost
― Output markets: countries where firm derives its revenues

― The presence of foreign competitors in domestic market affects a firm’s operating exposure.

 Accounting exposure is the exposure to changes in exchange rates as a result of an entity:

― Entering into foreign currency transactions that result in contractual rights and obligations
― Having to translate foreign currency financial statements from local currencies of foreign
operations to group’s reporting currency for consolidated financial reporting

― Quantifiable and directly impacts the income statement or statement of financial position
Types of Foreign Exchange Exposures
How changes in FX rates affect a firm’s exposures:
Market rate movements Firm’s strategies and
(due to macro-economic, operations (including
political forces and govt. foreign transactions and
monetary policies) operations)
Jointly determine

FX exposures

Accounting exposure Operating exposure

Impacts the reported Affects the competitive

earnings and statement of position of entity and value
financial position items of the firm
Types of Foreign Exchange Exposures
Accounting exposure:

Further sub-divided into transaction and translation exposure:

―Transaction exposure results in gains or losses that affect cash flows.

―Translation exposure results in gains or losses that do not affect cash flows.
Types of Foreign Exchange Exposures
Accounting Exposure (Quantifiable)

Transaction exposure:
Translation exposure:
Arises from foreign currency
Arises from translation of foreign currency
transactions e.g., account receivable
financial statements of foreign operations
denominated in a foreign currency

Results in transaction gains or losses Results in translation gains or losses

Recorded in the books Presented in consolidated

of the individual entity financial statements (group level)
Concept of Functional Currency
Functional currency:
―The currency of the primary economic environment in which the entity operates.
―A firm’s primary environment is NOT determined by national or political
boundaries.

Example: NOL (Neptune Orient Lines) is a Singaporean container shipping company.

―NOL’s revenue is mainly in form of freight charges, with significant proportion of
operating costs attributable to fuel oil.
―Prices of freight charges and fuel oil are denominated in US dollars (main currency
in shipping and commodities).
―Functional currency: USD; NOT SGD
Concept of Functional Currency
Factors to determine an entity’s functional currency
Primary factors:
―Currency that mainly influences the sale prices of goods and services
―Currency that mainly influences the labor, material and other cost of goods and
services

Secondary factors:
―Currency in which financing is obtained
―Currency in which receipts from operating activities are retained
Foreign Currency Transactions of
a Stand-alone Entity
Accounting Exposure

Transaction exposure:
Translation exposure:
Arises from foreign currency
Arises from translation of foreign currency
transactions* e.g., account receivable
financial statements of foreign operations
denominated in a foreign currency

Results in transaction gains or losses Results in translation gains or losses

Recorded in the books Presented in consolidated

of the individual entity financial statements (group level)

*A foreign currency transaction is a transaction denominated

in a currency other than the entity’s functional currency.
Foreign Currency Transactions of
a Stand-alone Entity
Monetary items
At foreign currency transaction date:
-The transaction is recorded at actual spot exchange rate.

At subsequent balance sheet reporting dates:

- Adjusted using the closing rate (the spot rate at the end of the reporting
period).
- Rationale: monetary items are contractual amounts that will be settled in a
specific currency therefore need to adjust for a change in spot rate.
Foreign Currency Transactions of
a Stand-alone Entity
Non-monetary items
Non-monetary items measured at historical cost:
- Items are measured and translated at historical rate (i.e., date of
transaction).
- No adjustment made at reporting date.
Non-monetary items measured at fair value:
- Are translated using the exchange rate when fair value was determined.
- Usually, the date is at reporting date and hence, closing rate is used.
Foreign Currency Transactions of
a Stand-alone Entity-Transaction Exposure
Items exposed to FX risk and have to be re-measured for changes in FX rates:
- Foreign currency monetary items
- Non-monetary items carried at fair value (not at historical cost)

 As a consequence of transaction exposure, this will give rise to an exchange gain or

loss
Foreign currency depreciates Foreign currency appreciates
Exposed asset Exchange loss Exchange gain

Exposed liability Exchange gain Exchange loss

Foreign Currency Transactions of
a Stand-alone Entity-Transaction Exposure
Treatment of Transaction Gains and Losses
Monetary items
―Exchange gain or losses are recognized in P&L (IAS 21:28)
―They are typically recognized:
• On the date of settlement of foreign currency monetary items; AND
• At reporting date.
Foreign Currency Transactions of
a Stand-alone Entity-Transaction Exposure
Treatment of Transaction Gains and Losses
Non-monetary items carried at FV
―Exchange gain or losses are recognized in the same way as the gain or loss on the
non-monetary item is recognized.
• E.g., FVOCI securities (fair value gain/loss recognized in equity): Exchange
differences is recognized in equity (OCI)
• Conversely, when fair value gain or loss on non-monetary item is recognized in
P&L, any exchange differences is also recognized in P&L.
Illustration 1:
Foreign Currency Transaction
Ace Corporation, whose functional currency is the local currency (DC) entered into the following
transaction during 20x2 and 20x3.

 1/11/20x2: Purchased 1,000 shares of Hi-tech Inc (listed company in US) at price of US$80 per
share. Ace classified the investment as trading securities (recorded at fair value).
― DC/US$ as at 1/11/20x2: DC 1.79
― DC/US$ as at 31/12/20x2: DC 1.82
― Price of Hi-tech as at 31/12/20x2: US$100

 10/12/20x2: Purchased equipment (recorded at cost) from German company invoiced at €100,000
to be settled on 28/2/20x3.
― DC/EUR€ as at 10/12/20x2: DC 2.82
― DC/EUR€ as at 31/12/20x2: DC 2.85
― DC/EUR€ as at 28/2/20x3: DC 2.95
Illustration 1:
Foreign Currency Transaction

1 November 20x2
Investment in
Dr Investment in trading securities 143,200 shares is non-
Cr Cash 143,200 monetary item
carried at FV.
Record purchase of shares at FX rate of DC1.79/US$1

10 December 20x2
Equipment is
Dr Equipment 282,000 translated at spot
Cr Accounts Payable (Euros) 282,000 rate at date of
purchase.
To record the purchase of equipment
Illustration 1:
Foreign Currency Transaction
Comprises:
31 December 20x2
exchange gain Dr Investment in trading securities 38,800
(2,400) and
Cr Gain in FV of trading securities 38,800
other gain in FV
(36,400) Gain in FV of Hi-tech’s shares

31 December 20x2 Account payables in

Dr Exchange loss 3,000 euros is monetary item
and is re-measured
Cr Accounts payable (euros) 3,000 using the closing rate at
To record exchange loss on A/P in euros reporting date.
Illustration 1:
Foreign Currency Transaction
28 February 20x3
Dr Exchange loss 10,000
Cr Accounts payable (euros) 10,000
To record exchange loss on A/P in euros

28 February 20x3
Dr Accounts payable (euros) 295,000
Cr Cash 295,000
To record settlement of A/P in euros at spot rate of DC 2.95/€1
Translation of Foreign Currency Financial
Statements
Accounting Exposure

Transaction exposure:
Translation exposure:
Arises from foreign currency
Arises from translation of foreign currency
transactions e.g., Account receivable
financial statements of foreign operations
denominated in a foreign currency

Results in transaction gains or losses Results in translation gains or losses

Recorded in the books Presented in consolidated

of the individual entity financial statements (group level)
Presentation vs. Functional Currency
Presentation currency:

―The currency in which the financial statements are presented.

―Entirely based on the discretion of the entity.

Presentation vs. Functional Currency
Functional currency of a foreign operation can be one of the following:
―Local currency of the foreign operation
―Parent company’s currency
―Other currency

Determining the functional currency of a foreign operation:

―Primary factors (i.e., currencies affecting sales prices and costs) should be first
considered with greater emphasis.
―Secondary factors (i.e., currencies affecting financing and operating activities)
are still applicable when further evidence is required.
―Additional factors are provided in HKAS 21.
Presentation vs. Functional Currency
Additional factors to determine functional currency of a foreign operation:
Indicators that Foreign operation’s Indicators that Foreign
Indicators functional currency is local operation’s functional currency is
currency parent’s functional currency
Foreign operation are carried with
(1) Operating relationship Foreign operations are carried out as
significant degree of autonomy from
with the parent an extension of the parent.
the parent.
(2) Transactions with the High proportion of total
Low proportion of total activities.
parent transactions.
(3) Cash flow Foreign operation’s cash flow do Foreign operation’s cash flow directly
interdependencies NOT directly affect parent company. affects the parent company.

(4) Financial Foreign operation is self-sufficient and Foreign operation is dependent on

independence not dependent on parent company. the parent company.
Presentation vs. Functional Currency
In event where indicators give mixed signals:

―Management will have to consider all factors taken together and

―Exercise judgment “to determine the functional currency that most

faithfully represents the economic effects of underlying transactions, events
and conditions.” (IAS 21:12)
Presentation vs. Functional Currency
Case 1:
 Australia Ltd (A) owns a subsidiary in Hong Kong, Dragon Ltd (D).

― D manufactures all goods in Hong Kong using local labour and sells them to
Hong Kong local customers. Selling prices are based on a 25% mark-up on
cost.

― The company has no long-term loans.

― All profits made by D are reinvested back into the business for expansion
purposes. The only remittances made to A are in the form of dividends.
Presentation vs. Functional Currency
Case 2:
 Australia Ltd (A) owns a subsidiary in Hong Kong, Dragon Ltd (D).

― D assembles all goods in Hong Kong using a combination of locally sourced

materials and materials manufactured by A.

― All goods are then exported and sold in Australia, based on selling prices
determined by A.

― The company has a small loan from an Australian bank.

Presentation vs. Functional Currency
Case 1 Case 2

Sales prices HK$ A$

Sales market HK$ A$

Expenses HK$ A$/HK$

Financing - A$

Intragroup transactions Low High

Conclusion: Functional currency = HK$ A$

Presentation vs. Functional Currency
 A stand-alone company is required to determine its functional currency in which its transactions are
conducted.
― The company is free to present its financial statements in any currency.
 For group entity:
― Application to group accounting:
Presentation currency of the group = presentation currency of the reporting entity (i.e., the parent)
IAS 21 specific two approaches to translate the financial statement:

Foreign Functional Presentation

Currency Currency Currency

Remeasurement Method Closing Rate Method

Presentation vs. Functional Currency
 Australia Ltd (A) owns a subsidiary in Hong Kong, Dragon Ltd (D).

Case 1 Case 2

“Foreign” currency HK$ HK$

Functional currency HK$ A$

Presentation currency A$ A$

Translation method Closing rate Remeasurement

Presentation vs. Functional Currency
Closing rate method is used to translate financial statements from functional to the
presentation currency.

As set out in IAS 21 Para 39, this method is applicable to:
―Stand-alone entity that records books in its functional currency but presents its
financial statements in another currency.
―Foreign operation (branch, subsidiary or associate) that records its books in its
functional currency but needs to translate its financial statements into parent’s
presentation currency for consolidation.
Translation Process
- Foreign Operations Integrated with Parent
Parent and the foreign operation is a single economic entity.
Foreign operation’s transactions are deemed to be the parent’s foreign currency
transactions.

Translation differences have a direct impact on the parent’s cash flows.

- FX gains or losses from remeasuring the foreign operation’s financial
statements are taken to P&L (except for non-monetary items at fair value).

Remeasurement procedures are the same as the treatment of foreign

transaction of a standalone entity.
- Hence, there is NO translation as functional currency of foreign operation is
the same as parent’s currency.
Translation Process
- Foreign Operation as an Independent Entity
Foreign operation is viewed as a passive investment by the parent.
Parent’s aims to obtain returns from foreign operations in the form of dividends
and capital appreciation.
Value of investment is influenced by:
― Profitability of foreign operation
― Change in exchange rates
Translation differences will not have an immediate impact on the parent’s cash
flow, therefore, they are taken to equity rather than income statement.
The translation from functional to presentation currency uses the closing rate
method.
Translation Process Summary
 Remeasurement/temporal method is used to translate a foreign currency to the functional currency.
― Stand-alone entity with foreign currency transactions. (Transaction Exposure)
― Foreign operations integrated with parent (functional currency = parent’s currency; deemed to
be the parent’s foreign currency transactions): remeasure its financial statements which has been
presented in its local currency into the functional currency. (Transaction Exposure)
Translation Process Summary
 Closing rate method is used to translate financial statements from functional to the presentation
currency using the closing rate method.
― Stand-alone entity that records books in its functional currency but presents its financial
statements in another currency. (Translation exposure)
― Foreign operation as an independent entity (functional currency = local currency): translate its
financial statements which has been recorded in its functional currency into parent’s presentation
currency for consolidation. (Translation exposure)
Translation Process Summary
Assume that parent’s functional and presentation currency is the dollar (US$)
Translation or Remeasurement (Assume
Foreign operation’s financial Foreign operation’s
that presentation currency is parent’s
statement functional currency
currency)
Functional currency (LC) is ≠ group’s
presentation currency ($).
The local currency (LC) The local currency (LC)
Translate into $ using the closing rate
method.
Functional currency is ≠ LC. All transactions
The local currency (LC) The parent’s functional currency recorded in LC are deemed foreign currency
($) transactions. Transactions recorded in LC need
to be remeasured from LC to $.
The parent’s functional currency The parent’s functional currency No translation or remeasurement; FS
($) ($) presented in $
The local currency (LC) Remeasure from LC into the functional
A third currency
currency; then translate into $
Any questions?
For next time…
• Read McGraw Hill Ch13, Wiley Ch8