The Effects of Changes in Foreign

Exchange Rates
FRK 300 – IAS 21

TJ HILL

© TJ Hill 2020
 CONTENTS

Introduction & Scope ......................................................................................................... 3

Definitions ............................................................................................................................ 4
Elaboration on Definitions............................................................................................... 5
Foreign Currency Transactions .......................................................................................... 7
Initial recognition ............................................................................................................. 7
Free-on-board (FOB) vs Cost-insurance-freight (CIF) ............................................... 8
Reporting at the end of the reporting period............................................................... 8
Exchange differences ..................................................................................................... 9
Buy rate vs Sell rate .................................................................................................... 10
Changes in functional currency .................................................................................. 10
Presentation Currency...................................................................................................... 10
Foreign Operation ............................................................................................................ 11
Income Tax Implications .................................................................................................. 11
Disclosure........................................................................................................................... 11
Basic Maths & Foreign Currencies ................................................................................... 12
Summary of a Summary (SOS) ......................................................................................... 13
Works Cited ....................................................................................................................... 14

© TJ Hill 2020
 INTRODUCTION & SCOPE

An entity can carry on foreign activities in two ways (IAS 21.1):

 Transactions in foreign currencies, or

 Foreign operations.

In addition, an entity may present its financial statements in a foreign currency (.1).

 This is sometimes because entities might decide to list their securities on

foreign stock exchanges.

The standard shall be applied (.2):

 in accounting for transactions and balances in foreign currencies,

o except for derivative transactions and balances that are within the
scope of IFRS 9.
 in translating the results and financial position of foreign operations that are
included in the financial statements of the entity by consolidation or the
equity method, and
 in translating an entity’s results and financial position into a presentation
currency.

Therefore, an entity might have foreign activities, and have to consider the effects of
translating to or from a foreign currency, when:

 A South African entity has transactions in a foreign currency, e.g. purchases

goods/services from an overseas supplier.
o Here, we focus on only one transaction.
 A South African parent company, might have foreign operations (i.e. a
foreign subsidiary) and might have to present consolidated financial
statements, and therefore, will have to convert the foreign operations’
financial statements to South African Rands.
o Here we focus on our foreign operations, thus multiple transactions.
 A South African company might want to translate their entire set of financial
statements to a foreign currency.
o Here we focus on our entire set of financial statements.

This standard does NOT apply to hedge accounting for foreign currency items, since
IFRS 9 applies to hedge accounting (.5).

This standard does NOT apply to the presentation in a statement of cash flows of
cash flow arising from transactions in a foreign currency, or the translation of cash
flows of a foreign operation, since IAS 7 deals with that (.7).

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 DEFINITIONS

The following terms are defined in IAS 21.8:

Closing rate - The spot exchange rate at the end of the reporting period.

Exchange difference – The difference resulting from translating a given number of

units of one currency into another currency at different exchange rates.

Exchange rate – The ratio of exchange for two currencies.

 e.g. $1:R17.07.

Foreign currency – A currency other than the functional currency of the entity.

Foreign operation – An entity that is a subsidiary, associate, joint arrangement or

branch of a reporting entity, the activities of which are based or conducted in a
country or currency other than those of the reporting entity.

 Note that the foreign operation need not necessarily be situated in a foreign
country to be a foreign operation. Its operations merely need to be
conducted in a currency other than those of the reporting entity, which will
most likely be a currency other than ZAR.

Functional currency – The currency of the primary economic environment in which

the entity operates.

 For a South African entity, this is usually ZAR.

 To determine the functional currency of an entity, we need to determine
where their primary economic environment is.
 Note that even if an entity operates in SA, their functional currency will be
ZAR, BUT they may still have a presentation currency that is not ZAR. This will
be the case, e.g. where an overseas company has a subsidiary in RSA – their
primary economic activities are in SA, which means their functional currency
is ZAR, however, their presentation currency might be the overseas currency.

Monetary items – Units of currency held and assets and liabilities to be received or
paid in a fixed or determinable number of units of currency.

 This definition is rather important, as will be seen later.

 Note, monetary items consist of 3 things:
o Units of currency held.
o Assets.
o Liabilities.

Presentation currency – The currency in which the financial statements are

presented.

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  The functional currency is not a choice, since it is based on where the entity
primarily operates, however, the presentation currency is a choice, and an
entity might have more than one presentation currency.
 We mostly deal with entities where the functional and presentation currencies
are the same, however, when dealing with IAS 21, we will look at where this
possibly is not the same.

Spot exchange rate – The exchange rate for immediate delivery.

 An interesting definition, however, it generally means the exchange rate on

the transaction date, since goods are generally ready for immediate delivery
on the transaction date.

ELABORATION ON DEFINITIONS

Functional currency

To determine the functional currency, one must determine the primary economic
environment in which the entity operates.

The primary economic environment in which an entity operates is normally the one
in which it primarily generates and expends cash (.9).

The following factors need to be considered (.9):

 the currency:
o that mainly influences sales prices for goods/services (usually the
currency in which sales prices are reflected); and
o of the country whose competitive forces and regulations mainly
determine the sales prices of its goods/services.
 the currency that mainly influences labour, material and other costs of
providing goods/services (often the same currency in which costs are
denominated).

The following factors also provide evidence of an entity’s functional currency (.10):

 the currency in which funds from financing activities (i.e. issuing debt and
equity instruments) are generated.
 the currency in which receipts from operating activities are usually retained.

Further, also consider the functional currency of a foreign operation, and whether its
functional currency is the same as that of the reporting (main) entity (.11):

 whether the activities of the foreign operation can be carried out as an

extension of the reporting (main) entity, rather than being carried out with a
significant degree of autonomy.
o E.g. the foreign operation only sells goods imported from the reporting
entity.

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  whether transactions with the reporting entity are a high or low proportion of
the foreign operation’s activities.
 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.
 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 from the reporting entity.

When the above indicators are mixed and not obvious, management uses
judgement in determining the functional currency (.12).

Management must give priority in the order of the abovementioned (.12).

The functional currency stays the same unless there is a change in those underlying
transactions, events and conditions (.13).

Therefore, to determine the functional currency, consider in the following order:

 The currency that influences sales prices.

 The currency in which costs are denominated.
 The currency in which funds from financing activities are obtained.
 The currency in which receipts from operating activities are retained.
 The functional currency of a foreign operation = functional currency of the
reporting entity:
o Whether the foreign operation is merely an extension of the reporting
entity.
o Whether transactions with the foreign operation are a high or low
proportion of all transactions.
o Whether cash flows of the foreign operation directly affect the
reporting entity.
o Whether the foreign operation has sufficient cash flows to operate on
its own.

Monetary items

The essential feature of monetary items is a right to receive (or an obligation to

deliver) a fixed or determinable number of units of currency.

 In English: We know how much money we have a right to receive or

obligation to pay.

Conversely, the essential feature of a non-monetary item is the absence of a right to

receive (or an obligation to deliver) a fixed or determinable number of units of
currency.

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Generally, for monetary items, one considers balances on the SFP. Only those
balances that will result in a “direct” inflow or outflow of cash will be monetary items,
e.g. trade debtors or trade creditors are the most obvious forms.

In speaking terms, I use “direct” however, when push comes to shove, consider
whether there is a right to receive or an obligation to deliver.

Inventories, PPE or right-of-use assets are examples of non-monetary items.

 Inventories are first converted to sales before it becomes cash, therefore, it is

non-monetary (not direct).
 Note: For inventories, there is not yet a right to receive cash.

The reason we identify this will be discussed in detail later, but basically it is because,
at the end of the reporting period, we need to adjust those amounts for which we
will receive or pay cash so that it accurately reflects the newest spot exchange rate
since when we receive or pay those amounts, it will come in or go out at the newest
exchange rate.

FOREIGN CURRENCY TRANSACTIONS

A foreign currency transaction is a transaction that is denominated or requires

settlement in a foreign currency (.20).

INITIAL RECOGNITION

A foreign currency transaction shall be recorded, on initial recognition in the

functional currency, by applying to the foreign currency amount the spot exchange
rate between the functional currency and the foreign currency at the date of the
transaction (.21).

 Therefore, determine the date of the transaction and the spot exchange rate
on that date.
 Apply the spot exchange rate on the date of the transaction to the
transaction to determine the amount to be recorded in the accounting
records.

The date of the transaction is the date on which the transaction first qualifies for
recognition in accordance with IFRS (.22).

 This is usually the date the risks and rewards of ownership are transferred (and
not necessarily when legal title/ownership is transferred) (Gray, 2020).

For practical reasons, a rate that approximates the actual rate at the date of the
transaction is often used, e.g., an average rate for a week or a month might be
used for all transaction in each foreign currency occurring in that period. However, if
the exchange rates fluctuate significantly, stick to the principle of using the spot
exchange rate (.22).

© TJ Hill 2020
  Sometimes it might be too costly or too time-consuming to keep determining
the spot exchange rate for each and every transaction that took place over
a week, and in that case, an average rate may be used.
 However, the most accurate and most correct is to always use the spot
exchange rate on the date of the transaction.

FREE-ON-BOARD (FOB) VS COST-INSURANCE-FREIGHT (CIF)

Free-on-board (FOB):

 Purchaser is responsible for all shipping and insurance costs.

 The seller is no longer responsible for the goods once delivered at the point of
dispatch.
o In practice, the seller usually delivers the goods at the point of dispatch
and sends the purchaser a bill of lading as proof that goods have
been shipped and that they are now absolved of all further
responsibilities.
 The risks and rewards thus transfer on dispatch.
 Transaction date = Date goods are shipped.

Cost-insurance-freight (CIF):

 Seller is responsible for all shipping and insurance costs.

 The seller is no longer responsible for the goods once delivered at the point of
dispatch.
o In practice, the seller usually delivers the goods at the point of dispatch
and sends the purchaser a bill of lading as proof that goods have
been shipped and that they are now absolved of all further
responsibilities.
 The risks and rewards thus transfer on dispatch.
 Transaction date = Date goods are shipped.

The transaction date for both CIF & FOB is the SAME = DATE GOODS ARE SHIPPED.
The only difference is who pays for the costs of shipping and insurance.

REPORTING AT THE END OF THE REPORTING PERIOD

At the end of each reporting period (.23):

 Monetary items  Translate it again using the closing rate.

 Non-monetary items:
o Measured @ historical cost in a foreign currency  Translate again
using the exchange rate on the date of transaction (in this case,
nothing changes, since you would have done this previously anyway).
o Measured @ fair value  Translate again using the exchange rate at
the date when fair value was measured (could or could not be

© TJ Hill 2020
 different depending on the situation). [PRACTICAL APPLICATION WILL
NOT BE TESTED].

Where the carrying amounts of items are determined by comparing two or more
amounts, e.g. IAS 2 (Cost vs NRV) and IAS 36 (CA vs RA), and the asset is non-
monetary (as is the case with inventories and PPE), and is measured in the foreign
currency, the carrying amount is determined by comparing (.25):

 Cost / CA, translated using the exchange rate on the date of transaction
(historical cost items), and
 NRV / RA, translated at the exchange rate when that value was determined
(i.e. end of the reporting period).

Therefore, we determine the respective amounts in foreign currencies first, then

translate using applicable exchange rates.

Note that the exchange rate used to translate cost / CA will be the transaction date
exchange rate, as opposed to the exchange rate used to translate NRV / RA, which
is the rate at the end of the reporting period.

EXCHANGE DIFFERENCES

Exchange differences are recognised in profit or loss (.28).

The exchange differences mentioned here are those where monetary items are
settled (received or paid), or where they are retranslated at the end of a reporting
period (.28).

This is not a problem where a transaction is concluded and a monetary item is

settled in the same accounting period, as the exchange difference relates to that
accounting period (.29).

However, where a transaction is concluded relating to a monetary item, and the

monetary item is only settled in a subsequent accounting period, the exchange
difference relates to separate accounting periods, i.e. the exchange difference
recognised in each period up to the date of settlement is determined by the
change in exchange rates during each period (.29).

However, this is usually automatically taken into account, since at the end of the
reporting period, the monetary item is translating according to the closing rate, and
the difference is recognised in profit or loss. Then when the monetary item is settled
in a subsequent period, the foreign currency difference from the last time it was
translated to the date of settlement is once again taken into account.

Note, interest accrues daily, and therefore, to determine interest for a period, the
average exchange rate is used.

© TJ Hill 2020
 BUY RATE VS SELL RATE
Foreign currency will always be purchased and sold at a financial institution such as
a bank.

Sell rate = the rate at which the bank sells the foreign currency to the user.

Buy rate = the rate at which the bank buys the foreign currency from the user.

Buy rate < Sell rate.

The difference between the buy rate and the sell rate is the compensation to the
bank for entering into the transaction.

 To settle a foreign creditor, the entity will have to buy foreign currency at the
bank’s sell rate.
 The foreign debtor pays us in foreign currency, the entity will have to sell the
foreign currency to the bank at the bank’s buy rate.

For accounting purposes, we rarely distinguish between the buy rate and sell rate,
and instead, use published rates on specific dates.

CHANGES IN FUNCTIONAL CURRENCY

When there is a change in an entity’s functional currency, the entity shall apply the
translation procedures applicable to the new functional currency prospectively from
the date of change (.35).

An entity translates all items into the new functional currency using the exchange
rate at the date of the change. The resulting translated amounts for non-monetary
items are treated as their historical cost (.37).

PRESENTATION CURRENCY

An entity may present its financial statements in any currency (or currencies) (.38).

If the entity’s functional currency and presentation currency are different, the entity
translates its results and financial position into the presentation currency (.38).

The following procedure is used (.39):

 Assets and liabilities  Translate using the closing rate at the date of the SFP.
 Income & expenses  Translate using the exchange rates at the date of the
transaction.
 All exchange differences are recognised in other comprehensive income
(OCI).

For income and expenses, an average rate may be used for practical reasons (since
there would be many transactions within the period and having to translate each

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one individually will be very costly and time-consuming), however, this is only
allowed if the exchange rates do not fluctuate significantly (.40).

The exchange differences are NOT recognised in profit or loss because the changes
in exchange rates have little or no effect on the present and future cash flows from
operations (.41).

 This is because all the income, expense, asset and liability amounts relate to
the past.

The cumulative amount of exchange differences is presented in a separate

component of equity until the disposal of the foreign operation.

 titled “Foreign currency translation reserve”.

FOREIGN OPERATION

The foreign operations results and financial position are translated into the entity’s
presentation currency in accordance with paragraphs 38-43 (which are the
paragraphs discussing translating to a presentation currency, as discussed in the
previous section above) (.44).

On the disposal of a foreign operation, the cumulative amount of the exchange

differences relating to that foreign operation, recognised in OCI and accumulated
in the SCE column “Foreign currency translation reserve”, will be reclassified from
equity to profit or loss when the gain or loss on disposal is recognised (.48).

 Only the above theory needs to be known, application is not tested in FRK
300.

INCOME TAX IMPLICATIONS

The accounting and tax treatment of exchange differences are generally the same,
with some exceptions.

 For FRK 300, assume the accounting and tax treatment for exchange
differences are the same.

DISCLOSURE

Par 51-57 provide the disclosure requirements.

The amount of exchange differences are presented in Profit before tax.

The net exchange differences recognised in OCI for translation to presentation

currency and translation to presentation currency from a foreign operation are
disclosed in SCE via the “Foreign currency translation reserve” column.

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 BASIC MATHS & FOREIGN CURRENCIES

When provided with an exchange rate as follows:

$1:R17.07

When given an amount in USD, e.g. $20 000, translate it by MULTIPLYING, i.e.

$20 000 x R17.07 = R341 400

(1 USD will give me R17.07, therefore 20 000 USD will give me R17.07 x 20 000)

When provided with an exchange rate as follows:

$0.05858:R1

When given an amount in USD, e.g. $20 000, translate it by DIVIDING, i.e.

$20 000 / 0.05858 = R341 400

(R1 will give me 0.05858 USD, therefore, (Rx)(0.05858) will give me $20 000 USD)

Therefore, when given exchange rates, carefully look at which currency is the 1.

 If the other currency is 1:RXX, then MULTIPLY.

 If ZAR is R1:XXX, then DIVIDE.
 The difference is NOT because the one is less than one (0.05858) as opposed
to R17.07 which is more than one! The difference is because the one currency
is the denominator (R1 / CUR1).
o i.e. ZAR1=USD5.45 still means that one must DIVIDE.

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© TJ Hill 2020
 SUMMARY OF A SUMMARY (SOS)

IAS 21 applies to:

 Foreign transactions.
 Foreign operations / translation to presentation currency.

Monetary items = money held, assets & liabilities received or paid in

fixed/determinable amount.

Foreign transactions (Golden rule: Exchange differences  P/L)

Date of transaction:

 Convert using SPOT EXCHANGE RATE.

End of reporting period:

 For monetary items:

o Measure @ CLOSING RATE.
o Recognise exchange difference in P/L.
 For non-monetary items  Do nothing.

When monetary items are paid/received:

 For monetary items:

o Measure @ SPOT EXCHANGE RATE.
o Recognise exchange difference in P/L.

Foreign operations / Presentation translation (Golden rule: Exchange differences  OCI)

End of reporting period:

 Convert the entire trial balance to presentation currency (ZAR).

Assets / Liabilities:

 Use CLOSING RATE.

Income / Expenses:

 Use SPOT EXCHANGE RATE on date of transaction (usually use average rate
for whole year).

Totals of trial balance:

 Calculate opening balance of Foreign currency translation reserve.

 Calculate closing balance of Foreign currency translation reserve (by getting
difference between DR & CR columns of trial balance translated)
 Difference between opening & closing balances  OCI.

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 WORKS CITED

Gray, W., 2020. IAS 21 Notes and class examples. Pretoria: University of Pretoria.

International Accounting Standards Board, 2017. International Accounting Standard

21 The Effects of Changes in Foreign Exchange Rates. London: IFRS Foundation.

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© TJ Hill 2020