It is necessary to translate because if the transactions were not denominated in a single

presentation currency, such as Australian dollars, then the financial statements could
be made up of accounts that were denominated in numerous currencies. Such
financial statements would be very difficult to understand.

At the end of the reporting period all foreign currency monetary assets and foreign
currency monetary liabilities must be translated to Australian dollar equivalents
(assumed to be the functional currency) using the exchange rate in place at the end of
the reporting period. As paragraph 23 of AASB 121 states:
At each end of the reporting period foreign currency monetary items shall be
translated using the closing rate.
Apart from a limited number of cases (for example, transactions relating to qualifying
assets and gains and losses pertaining to certain hedges), gains or losses on translating
the foreign currency monetary items must be treated as either expenses or income of
the reporting period and included within profit or loss. This is consistent with
paragraph 28 of AASB 121 which states:
Exchange differences arising on the settlement of monetary items or on
translating monetary items at rates different from those at which they were
translated on initial recognition during the period or in previous financial
statements, shall be recognised in profit or loss in the period in which they arise,
except as described in paragraph 32.

When a transaction occurs that is denominated in a foreign currency, that transaction

should initially be translated to the functional currency at the exchange rate in place at
the date of the transaction (also referred to as the ‘spot rate’). This is consistent with
paragraph 21 of AASB 121 which states:
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.

If the exchange rate moves against the Australian dollar and the debt is outstanding
then this will result in an increase in the Australian dollar equivalent of the amount
that is payable. This increase is to be treated as an expense entitled ‘loss on foreign

currency transactions’ (or similar). It is not to be adjusted against the cost of the
inventory.
AASB 123
Borrowing Costs provides guidance in relation to qualifying assets. The
standard relates to borrowing costs, which are broadly defined within the standard as
interest and other costs incurred by an entity in connection with the borrowing of
funds. Exchange rate differences generated in relation to outstanding loans would be
considered to be borrowing costs.
A ‘qualifying asset’ is defined in AASB 123 as an asset that necessarily takes a
substantial period of time to get ready for its intended use or sale. According to
paragraph 7 of AASB 123:
Depending on the circumstances, any of the following may be qualifying assets:
(a) inventories
(b) manufacturing plants
 (c) power generation facilities
(d) intangible assets
(e) investment properties
(f) bearer plants.
Financial assets, and inventories that are manufactured, or otherwise produced,
over a short period of time, are not qualifying assets. Assets that are ready for
their intended use or sale when acquired are not qualifying assets.
AASB 123 requires that borrowing costs (which include the foreign exchange
differences) that relate to qualifying assets should be included in the cost of
acquisition of the asset, to the extent that they arise before the assets cease to be
qualifying assets. Specifically, paragraph 8 of AASB 123 states:
An entity shall capitalise borrowing costs that are directly attributable to the
acquisition, construction or production of a qualifying asset as part of the cost of
that asset. An entity shall recognise other borrowing costs as an expense in the
period in which it incurs them.
Only those differences occurring before an asset ceases to be a qualifying asset should
be included. The exchange differences included in the cost of qualifying assets for the
financial year are the amounts that would otherwise have been included within the
period’s profit or loss. The amount capitalised as the cost of the asset shall not exceed
its recoverable amount. If exchange differences cause the recoverable amount to be
exceeded, the excess should be written-off to profit or loss.
As indicated above, where a qualifying asset is not involved, there is a general rule
that exchange difference relating to monetary items shall be brought to account in
profit or loss in the period in which the exchange rate changes.

We must refer to AASB 9 Financial Instruments for the rules pertaining to accounting
for hedging transactions.
Hedging refers to actions taken, whether by entering into a foreign currency contract
or otherwise, with the objective of mitigating possible adverse financial effects of
movements in exchange rates.
To minimise the risk associated with foreign currency monetary items, an entity may
enter a hedge contract. By entering into an agreement which takes a position opposite
to the original transaction, an entity can minimise its exposure to foreign currency
movements. For example, if an entity is required to pay an outstanding obligation that
is denominated in a foreign currency, then it can reduce or eliminate its risk to foreign
currency movements by entering an agreement with a third party, with that third party
agreeing to supply the foreign currency at a predetermined rate. For example, if the
entity had purchased some inventory at a cost of US$1 million (when the exchange
rate was A$1.00 = US$0.65) for which payment was not due for one month, then it
can eliminate its risk by entering a forward-rate agreement with a bank (this would be
a ‘hedging arrangement’) in which the bank will agree to supply US$1 million in one
month’s time at a forward rate of A$1.00 = US$0.62. This means the entity has
locked the price in to $1 000 000 0.62 = A$1 612 903. That is, regardless of what
happens to exchange rates, the entity will pay A$1 612 903 for the goods (and the
inventory would be the hedged item). The entity effectively will have a foreign
currency receivable, and a foreign currency payable for the same amount,
denominated in the same currency. Any gains or losses on one will be offset by gains
or losses on the other. If the exchange rate improves from the perspective of the
Australian dollar, the entity would gain on the liability with the overseas supplier (it
would owe them less Australian dollars), which will be fully offset by the loss on the
agreement with the bank (the value of the US Dollars to be received from the bank
would have decreased). If the value of the Australian dollar declines then the opposite
effects will occur.

A foreign currency monetary item is considered to be perfectly hedged if the gains or

losses on the hedge contract (perhaps a forward-rate agreement with a bank—this
would be called the hedging instrument) offset the losses or gains on the primary
transaction (such as a purchase or sale of inventory to an overseas party—this would
be the hedged item). For example, if a reporting entity had sold inventory for US$100
000 to a US customer and also had a forward-exchange-rate agreement with the bank
in which the bank agreed to buy US$100 000 from the entity at a predetermined rate,
then the overseas sale contract would be considered to be perfectly hedged.

A hedging instrument is the instrument that is being used to reduce the financial risks
associated with the hedged item. It can be a designated derivative or (for a hedge of
the risk of changes in foreign currency exchange rates only) a designated non-
derivative financial asset or non-derivative 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.
The hedged item is the item that exposes an entity to the risk of changes in fair value
or future cash flows and these risks are risks the entity would seek to eliminate or
reduce through the use of a hedging instrument within a hedging arrangement. A
hedged item is defined in AASB 9 as:
A hedged item can be a recognised asset or liability, an unrecognised firm
commitment, a forecast transaction or a net investment in a foreign operation. The
hedged item can be:
(a) a single item; or
(b) a group of items (subject to paragraphs 6.6.1–6.6.6 and B6.6.1–B6.6.16).
A hedged item can also be a component of such an item or group of items (see
paragraphs 6.3.7 and B6.3.7–B6.3.25).
Hedge accounting attempts to match the timing of profit or loss recognition on the
hedging instrument with the profit or loss on the hedged item—but only when the
hedging instrument meets specific requirements.
Why it is important to understand the difference between the hedged item and the
hedging instrument is that the gains or losses on either must be separately accounted
for. All gains or losses on the hedged item are to be included in profit or loss in the
period in which they arise (unless the hedged item is a ‘qualifying asset’), whereas the
treatment of any gains or losses on the hedging instrument will be determined by type
of hedging arrangement involved, and its ‘effectiveness’. As the text indicates, gains
or losses on the hedging instrument within a cash flow hedge can initially be taken to
equity and then transferred to profit or loss as necessary to offset gains or losses on
the hedging item. By contrast, gains or losses on the hedging instrument associated
with a fair value hedge will go to profit or loss in the period in which the gain or loss
arises.

A foreign currency swap arises where an obligation related to a loan denominated in

one currency is swapped for a loan denominated in another currency.
 For example, if a particular organisation has a number of receivables that are
denominated in a foreign currency, then changes in spot rates may potentially create
sizeable foreign currency gains, or sizeable foreign currency losses. If that same
organisation is able to convert some of its domestic loans into foreign currency loans,
of the same denomination as its receivables, then it will be able to effectively insulate
or hedge itself from the effects of changes in spot rates. Such an organisation may
seek to find another entity that is prepared to swap its foreign currency loans for the
organisation’s domestic loans. That is, if we have receivables and payables that are
both denominated in another particular foreign currency, then changes in the spot
rates will create gains on one but losses on the other. To the extent that the receivables
and payables are for the same amount and denominated in the same currency, the
losses on one monetary item (perhaps the foreign currency payable which would be
considered to be the hedged item) will be offset by gains on the other monetary item
(perhaps the foreign currency swap, which would be considered to be the hedging
instrument).

5 June 2018
Dr Inventory 543 478
Cr Accounts payable 543 478
543 478 = 250 000 0.46
30 June 2018
Dr Loss on foreign currency 24 704
Cr Accounts payable 24 704

Carrying amount of foreign currency payable 543 478

Value of foreign currency payable at 30 June 2018: 250 000 0.44 568 182
Loss on foreign currency payable 24 704

Background information
Hedging instruments would include such things as forward foreign currency exchange
contracts (forward contracts) and interest rate swaps. The item being hedged is
somewhat obviously referred to as the ‘hedged item’. It is defined as follows:
A hedged item is an asset, liability, firm commitment, highly probable forecast
transaction or net investment in a foreign operation that (a) exposes the entity to
risk of changes in fair value or future cash flows and (b) is designated as being
hedged.
The above definition of a hedged item makes reference to a ‘highly probably forecast
transaction’. This would include an anticipated future transaction which is currently
uncommitted. A ‘firm commitment’ (also referred to in the above definition) would
include, for example, a purchase order to buy inventory, in say, three months, as is the
case in this question. It would also include a liability for goods purchased overseas.
Hedge accounting attempts to match the timing of profit or loss recognition on the
hedging instrument with the profit or loss on the hedged item—but only when the
hedging instrument meets specific requirements. If a transaction is designated as a
cash flow hedge, gains and losses on the hedging instrument will not generally need to
 be included within profit or loss until such time as the underlying transaction (for
example, the sale or purchase of goods) occurs.
A firm commitment is defined in AASB 9, as a ‘binding agreement for the exchange
of a specified quantity of resources at a specified price on a specified future date or
dates’. So a firm commitment is a contractual obligation not yet recognised in the
statement of financial position. In other words, there is no recorded asset or liability.
If the entity was using a fair value hedge then the unrecognised firm commitment will
be recorded as an asset or liability that has risk exposure at some future date. An
example of an unrecognised firm commitment would be a non-cancellable purchase
order.
Again, reiterating some of the above points, for a cash flow hedge (which might be
undertaken to minimise the risk that a future expected cash flow, such as a payable
denominated in a foreign currency, might fluctuate in a manner unfavourable to the
entity), the gain or loss on measuring the hedged item (which for a cash flow hedge
would be the amount payable to the overseas supplier) at fair value is to be treated as
part of the period’s profit or loss. The gain or loss on the hedging instrument is
initially to be transferred to equity (and included in ‘other comprehensive income’),
but subsequently transferred to profit or loss as necessary to offset the gains or losses
recorded on the hedged item. If the gains or losses on the hedged item are occurring at
the same times as the offsetting gains or losses on the hedging instrument are arising
then both lots of gains or losses can be taken directly to profit or loss (thereby
offsetting each other either wholly or partially). At the conclusion of the hedging
arrangement, any amount still in equity relating to the hedging instrument is to be
transferred to profit or loss.
It is assumed that the hedge arrangement meets the five conditions necessary to permit
the entity to apply hedge accounting. The hedge contract was entered into before the
date of purchase and relates specifically to the purchase of the inventory. It is a hedge
of a firm commitment. This means the exchange differences on the firm commitment,
to the extent that they occur up to the date of the purchase, and the costs arising at the
time of entering the transaction can be deferred and included in the measurement of
the purchase price of the inventory.
Gains or losses on the hedging instrument (forward contract) are calculated using the
following information:
Date Spot Forward Receivable on forward Amount payable Fair value of
Gain/(loss) rate rate rate contract (a)
on forward forward on forward
contract (b) contract
contract (c) (d)

1 March 2018 0.45 0.42 3 571 429 3 571 429 – –

1 June 2018 0.43 0.40 3 750 000 3 571 429 178 571 178 571
30 June 2019 0.39 0.36 4 166 667 3 571 429 595 238 416 667
1 August 2019 0.41 0.41 3 658 537 3 571 429 87 108 (508 130)

87 108
Notes to the above table
a Determined by dividing £1.5m by the respective dates’ forward rate. This right
refers to the amount to be received from the bank, the value of which will fluctuate
as the forward rate changes. Although Kanga Limited has been able to ‘lock in’ a
particular forward rate (being 0.42), because the bank will negotiate different
 forward rates at different times the fair value of the receivable will change across
time. For example, if the forward rate that was available in June was 0.40 then
anybody entering a forward rate on that date to receive £1.5m on 1 August 2018
would be required to pay $3.75m. This means that the forward rate contract has a
value of $178 571—which is its fair value. Gains or losses in the value of this
forward rate contract will act to offset the gains or losses in the value of the amount
payable to the overseas supplier.
b The obligation (amount payable) represents the amount that must be paid to the
bank using the forward rate negotiated with the bank and is fixed in absolute terms
for the contracted party. This amount is fixed regardless of what happens to spot
rates, or what forward rates the bank offers on other forward rate contracts.
c We have calculated a fair value for the hedging instrument (the hedging instrument
being the forward rate contract). It is a requirement of AASB 9 that a fair value be
attributed to the hedging instrument. The fair value represents the amount for
which an asset could be exchanged, or a liability settled, between knowledgeable,
willing parties in an arm’s length transaction. In this situation, the fair value will
change as the available forward rate being offered by the bank changes. For
example, when the contract is originally negotiated, the bank is assumed to be
offering the forward rate of A$1.00 = £0.42 for the delivery of UK pounds on 1
August 2018 to any interested parties. Therefore, the contract itself has no fair
value. However, if on 1 June the bank is only prepared to offer a forward rate for
delivery of UK pounds of A$1.00 = $£0.40, then if Kanga Ltd was able to transfer
its contract to another party needing US dollars on that date, given the other
options available to that other party, that party would be prepared to pay up to $178
571 for the contract, which equates to ($1 500 000 ÷ 0.42) – ($1 500 000 ÷ 0.40).
The fair value of the contract would be deemed to be $178 571. There is also a
requirement that the financial instrument—in this case the forward contract—be
measured at the present value of the future cash flows. Because the life of the
forward contract is less than 12 months it has been decided on the basis of
materiality not to discount the associated cash flows to present value in this worked
example. In other examples in this chapter, no discounting will be applied to
forward contracts with lives of less than 12 months.
d The gain or loss on the forward rate contract represents the change in the fair value
of the forward rate contract.
Accounting entries
1 March 2018
No entry is required here as the fair value of the forward rate contract agreement is
assessed as being zero, as is the value of the firm commitment.
1 June 2018
Dr Forward contract (financial asset) 178 571
Cr Cash flow hedge reserve (gain included in OCI) 178 571
(to record changes in the fair value of forward contract)

Dr Cash flow hedge reserve (OCI) 178 571

Cr Inventory (asset) 178 571
(to transfer the lance of the cash flow hedge reserve to the cost of the asset on the date
the asset is acquired)
1 June 2018
Dr Inventory 3 488 372
Cr Accounts payable 3 488 372
(to record purchase of inventory at the purchase date’s spot rate (£1 500 000 ÷ 0.43
= $3 488 372)
30 June 2018
Dr Forward contract (asset) 416 667
Cr Gain on forward contract (included in profit or loss) 416 667
(to record change in fair value of forward contract)
30 June 2018
Dr Foreign exchange loss (included in profit or loss) 357 782
Cr Accounts payable 357 782
(to record foreign exchange loss on accounts payable)
Value of accounts payable as at 30 June 2018: 1 500 000 ÷ 0.39 = 3 846 154
Value of firm commitment as at 1 June 2018: 1 500 000 ÷ 0.43 = 3 488 372
357 782
1 August 2018
Dr Loss on forward contract (included in profit or loss) 508 130
Cr Forward contract (asset) 508 130
(to record change in fair value of forward contract)
1 August 2018
Dr Accounts payable 187 617
Cr Foreign exchange gain (included in profit or loss) 187 617
(to record foreign exchange loss on accounts payable)
Value of accounts payable as at 1 August 2018: 1 500 000 ÷ 0.41 = 3 658 537
Value of firm commitment as at 30 June 2018: 1 500 000 ÷ 0.39 = 3 846 154
187 617
1 August 2018
Dr Accounts payable 3 658 537
Cr Forward contract 87 108
Cr Cash 3 571 429
(to settle accounts payable. In this example, the other party to the forward rate
agreement—the bank—has actually made a loss on the transaction given the direction
the exchange rates have moved. The total amount of cash ultimately paid by Kanga
Ltd equals the amount that was originally negotiated in the forward rate contract with
the bank, this being $3 571 429)
Where an entity controls other entities there is a requirement to consolidate the
financial statements of the parent entity with those of the controlled entities (the
subsidiaries). Prior to consolidation, it is necessary that all the financial statements are
denominated in the same currency (the presentation currency), otherwise the
consolidated amounts would tend towards being meaningless. Translation of accounts
is required where the presentation currency is different from the functional currency.

Often the foreign operation performs its operations in a functional currency other than
that of the parent entity, a currency that is independent of the effects of movements in
their parent entity’s domestic currency. As such, the foreign operation insulates itself
from the effects of variations in the exchange rates between the parent’s currency and
its own currency. The parent entity will not be exposed to foreign exchange gains and
losses in relation to the foreign operation’s cash flows. Any increase or decrease in
the Australian dollar equivalent of the foreign operation’s assets will at least in part be
offset by changes in the Australian dollar equivalent of the foreign operation’s
liabilities. The exposure will be limited to the difference between the assets and the
liabilities—that is, limited to the net assets of the foreign operation.
Because the foreign operation often acts independently, with limited cash flow
influences on or interactions with the parent entity, any gains or losses related to
translating the net assets to a particular presentation currency will not be treated as
part of profit or loss, but will be transferred to reserves. The gains or losses are
considered to be unrealised from the parent entity’s perspective. AASB 121,
paragraph 41, states:
These exchange differences are not recognised in profit or loss because the
changes in exchange rates have little or no direct effect on the present and
future cash flows from operations. The cumulative amount of the exchange
differences is presented in a separate component of equity until disposal of the
foreign operation.

Presentation currency is defined in AASB 121 as the currency in which the financial
statements are presented. Functional currency is defined as the currency of the
primary economic environment in which the entity operates.
AASB 121 provides very little guidance in terms of determining the appropriate
presentation currency. As a general principle, in determining the presentation currency
consideration needs to be given to the currency in which the general purpose financial
statements should be prepared. We need to consider the needs of the financial
statement readers, who are dependent upon the general purpose financial statements.
If, for example, the entity’s shareholders primarily reside within Australia, then there
would be an expectation that the presentation currency would be Australian dollars.
As we know, the presentation currency might not be the same as the functional
currency. This might happen, for example, when a parent company residing within
Australia controls a subsidiary company that resides in a foreign country, for example,
within South Africa. If the subsidiary operates within South Africa, and that entity
sells its goods and purchases its factors of production in South African currency, then
its functional currency is likely to be the South African rand. However, for the
purposes of translating the results for Australian users, the presentation currency
would probably be Australian dollars.
All assets and liabilities of the foreign operation are translated using the spot rate
applicable at the end of the reporting period. Specifically, paragraph 39 of AASB 121
states:
 The results and financial position of an entity whose functional currency is not
the currency of a hyperinflationary economy shall be translated into a different
presentation currency using the following procedures:
(a) assets and liabilities for each statement of financial position presented (ie
including comparatives) shall be translated at the closing rate at the date of
that statement of financial position;
(b) income and expenses for each statement presenting profit or loss and other
comprehensive income (ie including comparatives) shall be translated at
exchange rates at the dates of the transactions; and
(c) all resulting exchange differences shall be recognised in other
comprehensive income.
While paragraph 39 of AASB 121 outlines the method of translating the assets,
liabilities, income and expenses of a foreign entity into a particular presentation
currency, AASB 121 does not address the translation of:
equity at the date of the investment, that is, pre-acquisition capital and
reserves
post-acquisition movements in equity other than retained profits or
accumulated losses
distributions from retained earnings.
This lack of guidance is in contrast with AASB 1012—the superseded (pre-2005)
standard. AASB 1012 did provide guidance on how to translate the above equity
items. These prior requirements would also be allowable under AASB 121, so in the
absence of guidance in AASB 121, we will apply the contents of Australia’s former
accounting standard that related to foreign currency transactions and translations—
AASB 1012—as they relate to equity items. AASB 1012 required:
Equity at the date of the investment, including in the case of a corporation, share
capital at acquisition and pre-acquisition reserves, is translated at the exchange
rate current at that date.
Post-acquisition movements in equity, other than retained earnings (surplus) or
accumulated losses (deficiency), are translated at the exchange rates current at the
dates of those movements, except that, where a movement represents a transfer
between items within equity, the movement is translated at the exchange rate
current at the date that the amount transferred or returned was first included in
equity.
Distributions from retained earnings (that is, dividends paid or proposed, or their
equivalent) are translated at the exchange rates current at the dates when the
distributions were first declared.

Income and expenses are translated at the exchange rates in place at the dates of the
various transactions. If expense and revenue transactions are considered to occur
uniformly throughout the period, then average rates may be used. As paragraph 40 of
AASB 121 states:
For practical reasons, a rate that approximates the exchange rates at the dates
of the transactions, for example an average rate for the period, is often used to
translate income and expense items. However, if exchange rates fluctuate
significantly, the use of the average rate for a period is inappropriate.