Chapter 8

Accounting for the

Effects of Changes
in Foreign Exchange
Rates

Copyright © 2016 by McGraw-Hill Education (Asia). All rights reserved.

1
Learning Objectives
1. Understand the concept of foreign exchange exposure;

2. Differentiate between operating exposure and accounting exposure;

3. Understand the concept of functional currency;

4. Understand the accounting treatment of foreign currency transactions;

5. Understand the effects on foreign exchange on disposal and partial disposal of

foreign operations;

6. Understand the procedures for translating foreign currency financial statements in

a non-hyperinflationary environment;

7. Understand the special issues relating to translation; and

8. Understand the difference between the effects on foreign exchange arising from
step-by-step and direct method of consolidation in complex group structure and its
effects on disposal. 2
Content

1. Introduction
Introduction
2. Types of Foreign Exchange Rate Management Regimes
3. How Exchange Rates Are Quoted
4. Spot Rate and Forward Rate
5. Types of Foreign Exchange Rate Exposures
6. Concept of Functional Currency
7. Foreign Currency Transactions of a Stand-alone Entity (IAS 21:20–26)
8. Translation of Foreign Currency Financial Statements
9. Special Issues
10. Evaluation of Translation Approaches

3
Introduction

Year1
974

Fixed / Official Exchange Rate International Monetary System

System • Floating exchange rate system
• Currencies were pegged to US • Volatility of exchange rates
Dollar
• Affect businesses reported
• US Dollar was pegged to gold
earnings.
prices

4
Content

1. Introduction
2.
2. TypesofofForeign
Types Foreign Exchange
Exchange Rate
Rate Management
Management Regimes
Regimes
3. Spot and Forward Rate
4. How Exchange Rates Are Quoted
5. Types of Foreign Exchange Rate Exposures
6. Concept of Functional Currency
7. Foreign Currency Transactions of a Stand-alone Entity (IAS 21:20–26)
8. Translation of Foreign Currency Financial Statements
9. Special Issues
10. Evaluation of Translation Approaches

5
Types of Foreign Exchange Rate
Management Regimes

Managed
Floating Rate – Currencies
Floating Rate
System
System
fluctuate freely
Exchange Rate according to
Exchange Rate
Linked to a
Linked to a Key demand and
Basket of
Currency
Currencies
supply.
– E.g. USD, GBP,
Currency Board
System AUD, CAD

6
Types of Foreign Exchange Rate
Management Regimes

Managed
Floating Rate – Largely based on
Floating Rate
System
System demand and
supply forces,
Exchange Rate
Exchange Rate
Linked to a – but the central
Linked to a Key
Basket of
Currency bank can freely
Currencies
intervene by
Currency Board buying or selling
System
the currency

7
Types of Foreign Exchange Rate
Management Regimes

Managed
Floating Rate – Exchange rate is fixed to
Floating Rate
System
System a key currency such as
USD (e.g. HK,
Exchange Rate
Exchange Rate Argentina)
Linked to a
Linked to a Key
Basket of
Currency – Affected by economic
Currencies
conditions/policies (e.g.

Currency Board inflation, money supply)

System of the key currency

8
Types of Foreign Exchange Rate
Management Regimes

Managed
Floating Rate – Exchange rate is
Floating Rate
System
System based on a basket of
currencies of their
Exchange Rate
Exchange Rate major trading partners.
Linked to a
Linked to a Key
Basket of (E.g. Singapore)
Currency
Currencies
– More stable than

Currency Board pegging currency to

System single country

9
Types of Foreign Exchange Rate
Management Regimes

Managed
Floating Rate – Money supply of
Floating Rate
System
System currency is backed by
an equivalent amount
Exchange Rate
Exchange Rate of a strong currency
Linked to a
Linked to a Key
Basket of (e.g. USD or EUR)
Currency
Currencies
– Shares many

Currency Board characteristics of

System fixed rate systems

10
Content

1. Introduction
2. Types of Foreign Exchange Rate Management Regimes
3.
3. HowExchange
How Exchange Rates
Rates AreAre Quoted
Quoted
4. Spot and Forward Rate
5. Types of Foreign Exchange Rate Exposures
6. Concept of Functional Currency
7. Foreign Currency Transactions of a Stand-alone Entity (IAS 21:20–26)
8. Translation of Foreign Currency Financial Statements
9. Special Issues
10. Evaluation of Translation Approaches

11
How Exchange Rates Are Quoted

• FX rate
– The price of a currency expressed in terms of another currency

• Exchange rates are quoted in two ways:

– Direct quotation:
 1 unit of foreign currency : X unit of domestic currency
– Indirect quotation:
 X unit of foreign currency : 1 unit of domestic currency

• To translate a direct quotation to an indirect quotation

– 1 unit of foreign currency/x unit of domestic currency

• To translate an indirect quotation to a direct quotation

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

12
Content

1. Introduction
2. Types of Foreign Exchange Rate Management Regimes
3. How Exchange Rates Are Quoted
4. Spot Rate and Forward Rate
4. Types of Foreign Exchange Rate Exposures
5. Types of Foreign Exchange Rate Exposures
6. Concept of Functional Currency
7. Foreign Currency Transactions of a Stand-alone Entity (IAS 21:20–26)
8. Translation of Foreign Currency Financial Statements
9. Special Issues
10. Evaluation of Translation Approaches

13
Spot Rate and Forward Rate

Foreign
Currency Market

Spot Rate Market:
Rates quoted for two
business days
after the trade day
Forward market:
Contractual agreement between two parties
where they agree to deliver one
currency in exchange for another, at rate
agreed upon today on a specified future
date, longer than two business days

Forward rate > Spot rate = Premium

Forward rate < Spot rate = discount

14
Spot Rate and Forward Rate
• Economic concept of interest parity
– Forward premium or discount on the exchange rate between two currencies is equal to
the difference in interest rates between two countries
 Assumption: perfect market conditions and free flow of capital
– If forward premium or discount on exchange rate ≠ difference in interest rates:
 Covered interest arbitrage occurs: arbitragers (currency traders) transfer funds to
country where interest rate is higher in order to earn higher return while covering
the FX risk with forward sales contract
– Consequences:
1. Large amount of funds flowing to higher interest rate countries  pressure
for interest rate to decrease
2. Outflow of liquidity in lower interest rate countries  pressure for interest
rate to increase
3. Forward sale creates downward pressure on forward rate of country with
lower interest rate.
4. 1, 2 and 3 continue until difference in interest rates is offset by FX premium
or discount

15
Content

1. Introduction
2. Types of Foreign Exchange Rate Management Regimes
3. How Exchange Rates Are Quoted
4. Spot and Forward Rate
5. Types of Foreign Exchange Rate Exposures
5. Types of Foreign Exchange Rate Exposures
6. Concept of Functional Currency
7. Foreign Currency Transactions of a Stand-alone Entity (IAS 21:20–26)
8. Translation of Foreign Currency Financial Statements
9. Special Issues
10. Evaluation of Translation Approaches

16
Types of FX Rate Exposures
How changes in FX rates affect a firm’s exposure
Market rate movements (due
Firm’s strategies and
to macro-economic, political
operations (including foreign
forces and govt. monetary
transactions and operations)
policies)

Jointly determine

FX exposure

Accounting exposure Operating exposure

Impacts the reported Affects the competitive

earnings and statement of position of entity and value of
financial position items the firm

17
Operating Exposure

• Not easily quantifiable

• Purchasing Power Parity
– Exchange rate changes between two countries = inflation differential between
two countries
– If the above does not hold, the real exchange rate between the two countries
has changed
– It will affect the competitive positions of firms operating in the two countries

• 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

18
Operating Exposure

• The extent of operating exposure of firm depends on

– Cost responsiveness and price responsiveness of its products to
changes in FX rates
o Cost responsiveness: extent to which costs change in response to
exchange rate changes

o Price responsiveness: extent to which selling price changes

because of exchange rate changes. Influenced by:
 Demand elasticity of goods produced
 Competitor response to price changes by a firm

o Operating exposure comes from mismatches between cost and

price responsiveness

19
Accounting Exposure

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)

20
Content

1. Introduction
2. Types of Foreign Exchange Rate Management Regimes
3. How Exchange Rates Are Quoted
4. Spot and Forward Rate
5. Types of Foreign Exchange Rate Exposures
6. Concept of Functional Currency
6. Concept of Functional Currency
7. Foreign Currency Transactions of a Stand-alone Entity (IAS 21:20–26)
8. Translation of Foreign Currency Financial Statements
9. Special Issues
10. Evaluation of Translation Approaches

21
Concept of Functional Currency

• Functional currency under IAS 21:

– Currency of the “primary economic environment in which the entity operates”
– Currency that influences the sale prices of goods and services
– Currency in which sales prices are denominated and settled

• Currencies other than the functional currency are foreign currencies

– The effects of exchange rate changes on a firm’s cash flows is measured and reported through
functional currency

• A firm’s primary environment is not determined by national or political boundaries

– Example: Neptune Orient Lines (NOL): 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: denominated in US dollars (main currency in shipping and
commodities)
– Functional currency: USD; NOT SGD

22
Factors to determine an Entity’s
Functional Currency (IAS 21:9-10)
1. Currency that mainly influences the sale prices of goods and
services;

2. Currency of country whose competitive forces and regulations

determine the sales prices of goods and services;

3. Currency that mainly influences the labour, material and other

cost of goods and services;

4. Currency in which financing is obtained;

5. Currency in which receipts from operating activities are retained.

23
Factors to determine an Entity’s
Functional Currency
• Primary indicators for identifying the functional currency: First three
indicators above (IAS 21:9)

• 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)

24
Foreign Operation’s Functional Currency

• Foreign operation’s functional currency can be one of the following:

– Local currency
Adopted in most situations
– Parent’s functional currency; or
– A third currency

• Additional factors to determine foreign operation’s functional

currency (IAS 21:11) aside from guidelines set out in (IAS 21 para 9
-10)

25
Additional Factors to Determine Functional
Currency of a Foreign Operation
Indicators that Foreign
Indicators that Foreign
operation’s functional
Indicators operation’s functional
currency is parent’s
currency is local currency
functional currency
Foreign operation are
Foreign operations are
Operating relationship with carried with significant
carried out as an extension
the parent degree of autonomy from
of the parent
the parent
Low proportion of total High proportion of total
Transactions with the parent
activities transactions
Foreign operation’s cash Foreign operation’s cash
Cash flow
flow do NOT directly affects flow directly affects the
interdependencies
parent company parent company
Foreign operation is self- Foreign operation is
Financial independence sufficient and not dependent dependent on the parent
on parent company company

26
Choice of Functional Currency

Nature of operating and financial relationship

between a parent and its foreign operation

Foreign operation operates

Foreign operation is
independently in economic
integrated with parent’s operation
and financial matters

Functional currency should be Functional currency

either local or a 3rd currency should be parent’s currency

Closing rate method Remeasurement Method

27
Foreign Operation as an Independent
Entity: Functional to Presentation Currency
• Features of closing rate method:

Items Rate

Assets and liabilities (both monetary and non-monetary) Closing rate

Income and expense items Actual or average rate
Translation gain or losses are taken to equity until disposal of foreign operation

• 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
– Effect of exchange rate movements is measured using closing rate
– Translation differences will not have an immediate impact on the parent’s cash flow,
therefore, they are taken to equity rather than income statement
– Cumulative translation difference is taken to income when foreign operation is disposed
28
Foreign Operations Integrated with Parent:
Functional to Presentation Currency

• 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,
thus they are taken to income statement
– Remeasurement procedures are the same as the treatment of foreign
transaction of a standalone entity

29
Exchange Rates Used for Translating
Balance Sheet Items
Balance Sheet Items Closing Rate Method Remeasurement Method
Share capital and pre-
acquisition retained Historical rate Historical rate
earnings
Post-acquisition retained Not translated using a Not translated using a
earnings single exchange rate single exchange rate
Monetary assets and Closing rate Closing rate
liabilities
Historical rate
Non-monetary assets and Closing rate (For items acquired before
liabilities acquisition date: rate at
acquisition date)
Non-monetary items at fair Rate at the date of the
value* Closing rate revaluation or FV
determination
Taken to equity (foreign Taken to income statement
Translation gains or losses currency translation (except* is taken to equity if
reserve) the revaluation gains or
losses is taken to equity)

30
Exchange Rates Used for Translating
Income Statement Items
Income Statements Items Closing Rate Method Remeasurement method

Sales, purchases,
expenses, revenues and
income statement items that Actual / average rate Actual / average rate
result in inflow/outflow of
monetary items
Historical rate of original
Costs of sales Actual / average rate
purchase of inventory
Historical rate of original
Depreciation, amortization
acquisition (if acquired
and other allocation of non- Actual / average rate
before acquisition date, use
monetary items
rate at acquisition date)
Dividends and other
Actual rate Actual rate
appropriation of profits

31
Content

1. Introduction
2. Types of Foreign Exchange Rate Management Regimes
3. How Exchange Rates Are Quoted
4. Spot and Forward Rate
5. Types of Foreign Exchange Rate Exposures
6. Concept of Functional Currency
7.
7. Foreign Currency Transactions
Foreign Currency Transactions of
of aa Stand-alone
Stand-aloneEntity
Entity(IAS
(IAS21:20–26)
21:20–26)

8. Translation of Foreign Currency Financial Statements

9. Special Issues
10. Evaluation of Translation Approaches

32
Foreign Currency Transactions of a
Stand-alone Entity (IAS 21:20-26)

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 exchange gains or losses Results in translation gains or losses

Recorded in the books Presented in consolidated

of the individual entity financial statements (group level)

33
Foreign Currency Transactions of a
Stand-alone Entity

Timeline of a typical foreign currency transaction

Foreign currency Financial year end Settlement of monetary

transaction recorded at Outstanding monetary asset/liability
actual (historical) asset/liability
exchange rate giving
rise to monetary asset
or monetary liability

IAS 21:21 requires a foreign currency transaction be recorded by applying to the

foreign currency amount the spot FX rate between the functional currency and foreign
currency on the date of transaction
34
Foreign Currency Transactions of a
Stand-alone Entity
• Monetary vs. Non-monetary items from foreign currency transaction:
– Monetary items are “units of currency held and assets and liabilities to be
received or paid in fixed or determinable number of units of currency”
 Key feature: right to receive (or obligation to deliver) a fixed or
determinable number of units of currency
– E.g. of Monetary assets or liability:
 Cash
 Time deposits in the bank
 Accounts and loan receivable/payable
 Tax payable (including deferred tax)
– E.g. of Non-monetary items:
 Investment in equity instruments
 Unearned revenue
 Non-refundable deposits

35
Foreign Currency Transactions of a
Stand-alone Entity
• At foreign currency transaction date:
– The transaction is recorded at actual spot rate

• At Subsequent balance sheet dates:

– Monetary items:
 Are adjusted using the closing rate at balance sheet date
 Rationale: monetary items are contractual amounts that will be settled in a
specific currency therefore need to adjust for a change in spot rate
– Non-monetary items measured at historical cost:
 No adjustment made at balance sheet date
 Items are measured and translated at historical rate (i.e. date of transaction)
– Non-monetary items measured at fair value
 Are translated using the exchange rate when fair value was determined

36
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 FV
– Re-measurement at balance sheet and settlement date will give rise to
exchange gains or losses

Foreign currency Foreign currency

depreciates appreciates
Exposed asset Exchange loss Exchange gain

Exposed liability Exchange gain Exchange loss

37
Treatment of Transaction Gains and
Losses
• Monetary items:
– Exchange gain or losses are recognized in the profit and loss of the
entity as they arise.
– They are typically recognized:
 On date of settlement of foreign currency monetary items
 At reporting date (Balance sheet date)

• 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. Available-for-sale investment (fair value gain/loss recognized in
equity): exchange differences is recognized in equity

38
Net Investment in Foreign Operation

• A monetary item in the form of a receivable or payable to a foreign operation

for which settlement is neither planned for nor it is likely to occur in the
foreseeable future.
− Such items (and their FX differences) are, in substance, a part of the entity’s net
investment in the foreign operation.
− In the foreign operation’s separate FS, the exchange differences are recognized in P/L
− In the consolidated FS, the exchange differences are recognized initially in OCI and
accumulated in equity. Upon disposal (or loss of control) of the net investment, the
cumulative amount are reclassified from equity to P/L. (Similar to the accounting treatment
for an autonomous foreign operation, it is considered a passive investment and thus the
closing rate method is applied here)

39
Illustration 1:
Foreign Currency Transaction
• Ace Corporation, whose functional currency is the domestic
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$80 per share. Ace classified the investment as
trading securities
 DC/US$ 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 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

40
Illustration 1:
Foreign Currency Transaction
1 November 20x2
Dr Investment in trading securities 143,200 Investment
in shares is
Cr Cash 143,200 non-
monetary
item carried
Record purchase of shares at FX rate of DC1.79/US$1 at FV

10 December 20x2
Equipment is
Dr Equipment 282,000 translated at
spot rate at
date of
Cr Accounts Payable (Euros) 282,000 purchase

To record the purchase of equipment

Comprises: 31 December 20x2

exchange
gain (2,400) Dr Investment in trading securities 38,800
and other
gain in FV Cr Gain in FV of trading securities 38,800
(36,400)
Gain in FV of Hi-tech’s shares
41
Illustration 1:
Foreign currency transaction
31 December 20x2 Account
payables in
Dr Exchange loss 3,000 euros is
monetary
item and is
Cr Accounts payable (euros) 3,000 re-measured
using the
To record exchange loss on A/P in euros (100k€ x [DC 2.85 – DC 2.82]) closing rate
at reporting
date
28 February 20x3
Dr Exchange loss 10,000
Cr Accounts payable (euros) 10,000
To record exchange loss on A/P in euros (100k€ x [DC 2.95 – DC 2.85])

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

42
Content

1. Introduction
2. Types of Foreign Exchange Rate Management Regimes
3. How Exchange Rates Are Quoted
4. Spot and Forward Rate
5. Types of Foreign Exchange Rate Exposures
6. Concept of Functional Currency
7. Foreign Currency Transactions of a Stand-alone Entity (IAS 21:20–26)
8. TranslationofofForeign
Translation Foreign Currency
Currency Financial
Financial Statements
Statements
9. Special Issues
10. Evaluation of Translation Approaches

43
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)

44
Presentation vs. Functional Currency

• A stand-alone company is required to determine its functional currency

• The company is free, however to determine its presentation currency
• For group entity:
– The presentation currency of the group is the presentation currency of the
parent company

• IAS 21 specific two approaches to translate the financial statement

Foreign Functional Presentation

Currency Currency Currency

Remeasurement Method Closing Rate Method

45
Functional Currency to Presentation
Currency
• Closing rate method is used to translate financial statements from
functional to the presentation currency

• 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 need to translate its financial
statements into parent’s presentation currency for consolidation

46
Foreign Currency to Functional Currency

• Remeasurement method is used to translate financial statements

from functional to the presentation currency

• This method is applicable to:

– A stand-alone entity that records its books in other currency but present
its financial statements in its functional currency
– A foreign operation that records its books in local currency but its
functional currency is the presentation currency (assumed to be the
same as the parent’s functional currency)

• Purpose of re-measurement is to achieve the same result as if the

transactions had been originally recorded in the functional currency

47
Translation Procedures
Assumed that parent’s functional and presentation currency is the dollar (US$)

Translation or Remeasurement
Foreign operation’s Foreign operation’s
(Assume that presentation currency
financial statement functional currency
is parent’s currency)

Functional currency (LC) is ≠ the

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 recorded in LC are
The local currency (LC) The parent’s functional deemed foreign currency
currency ($) transactions. Transactions recorded
in LC need to be remeasured from LC
to $.

The parent’s functional The parent’s functional No translation or remeasurement; FS

currency ($) currency ($) presented in $

The local currency (LC) Remeasure from LC into the functional

A third currency
currency; then translate into $

48
Translation Exposure

• Translation gain or loss arises when exchange rates used in translating current
year’s financial statements are different from those used in previous years

• Translation exposure = net amount of assets or liabilities in a foreign currency

balance sheet that is translated at the closing rate. Closing rates are different
on different balance sheet dates

Translated at Closing Rate Translated at Historical rate

Net assets (A-L) exposed to Net assets preserve original
changes in exchange rate carrying amounts and do not give
(translation exposure) rise to translation difference

49
Sources of Translation Difference
Under Closing Rate Method
• Opening net assets translated at the previous closing rate versus
the current closing rate;

• Effect of exchange rate on increase or decrease in net assets during

the year. Examples of changes in net assets:
– Net profit or loss for the year,

– Dividend paid during the year,

– Injection of new capital during the year

50
Translation Exposure: Remeasurement
Method
• Under remeasurement method, monetary items and non-monetary items that are
measured at fair value are the exposed items as they are translated at closing rate

• Net exposed position can be either

– Net monetary asset
– Net monetary liability

• Sources of Translation Difference:

– Effect of exchange rate changes arise on:
 Opening/closing net monetary items
 Increase/decrease in monetary items during the year
 Non-monetary items measured at fair value
 Change in basis of measurement for non-monetary items (e.g. from historical cost to
NRV)
 Revaluation of non-monetary items during the year (e.g. property revaluations)

51
Translation Exposure: Remeasurement
Method
• Under remeasurement method, exchange gain or loss on any non-
monetary items measured at fair values (i.e. revaluation or change
in basis of measurement) is accounted in the same way that gain or
loss on the revalued item is recognized

• Example:
– Gain/loss on revaluation of land is taken to equity
– Gain/loss on Available for Sale (AFS) instrument is taken to equity

52
Illustration 2:
Translation Example
On 31 December 20x0 Durian Pie Ltd, whose functional and presentation currency is the dollar
($), acquired entire share capital of Mango Pie, a foreign company whose financial statements
are prepared in local currency (FC).
MANGO PIE
Statement of financial position at 31.12.20x0
Assets FC
Fixed assets 290,000
Prepaid insurance 18,000
Inventories 60,000
Account receivables 50,000
Cash 14,000
Accounts payable (100,000)
Net assets 332,000

Share capital 300,000

Retained earnings 32,000
Total Equity 332,000

53
Illustration 2:
Translation Example
Additional information
a. Fixed assets comprised of the following

Net book value (FC) Annual depreciation

Land 50,000 0
Building 100,000 5,000
Equipment 140,000 28,000
290,000 33,000

54
Illustration 2:
Translation Example
Mango Pie’s financial statements for the year ended 31 December 20x1 and 20x2
are as follows:
Income statement for years 31 Dec 20x1
  FC
Sales 600,000
COGS (380,000)
Gross profit 220,000
Depreciation (33,000)
Insurance (12,000)
Operating expenses (78,000)
Profit before tax 97,000
Taxation (20,000)
Profit after tax 77,000
Dividend paid (25,000)
Retained profit for year 52,000

55
Illustration 2:
Translation Example
Balance sheet at 31 Dec 20x1
   FC
Fixed assets (net) 257,000
Inventories 80,000
Prepaid insurance 6,000
Account receivables 70,000
Cash 89,000
Accounts payable (98,000)
Tax payable (20,000)
Net assets 384,000

Share capital 300,000

Retained earnings 84,000
Revaluation surplus 0
Total equity 384,000

56
Illustration 2:
Translation Example
Additional information:
1. Sales and expenses were incurred evenly throughout each reporting period

2. Relevant exchange rates are as follows:

1FC =
At 31.12.20x0 $0.81
Average for 20x1 $0.78
At 31 Dec 20x1 $0.76
Average rate when closing inventories (20x1) acquired $0.77
Average rate when closing inventories (20x2) acquired $0.74
Average rate for 20x2 $0.75
Dividends paid (20x1) $0.77
Dividends paid (20x2) $0.72
30.09.20x2 $0.71
At 31.12.20x2 $0.70

57
Illustration 2:
Translation Example
Required:
(a) Translate the 20x1 financial statements of Mango Pie into dollars
assuming that Mango Pie’s functional currency is the local
currency (FC)

(b) Remeasure the 20x1 financial statements of Mango Pie into

dollars assuming that Mango Pie’s functional currency is the
dollar.

58
Illustration 2:
Translation Example
Translated Profit & Loss Account (Closing Rate method)
       
  FC Rate $
Sales 600,000 0.78 468,000
COGS (380,000) 0.78 (296,400)
Gross profit 220,000   171,600
Sales and
Depreciation (33,000) 0.78 (25,740) expenses occur
Insurance expense (12,000) 0.78 (9,360) evenly throughout
year
Operating expenses (78,000) 0.78 (60,840)
Profit before tax 97,000 75,660
Taxation (20,000) 0.78 (15,600)
Profit after tax 77,000 60,060
Represent
Dividend paid (25,000) 0.77 (19,250) entirely pre-
Retained profit for year 52,000 40,810 acquisition
earnings
Retained profit b/f (1.1.20x1) 32,000 0.81 25,920 (translated at
Retained profit c/f (31.12.20x1) 84,000   66,730 rate as at
acquisition)

59
Illustration 2:
Translation Example
Statement of Financial Position at 31.12.20x1
Assets FC Rate $
Fixed assets 257,000 0.76 195,320
Inventories 80,000 0.76 60,800
Prepaid insurance 6,000 0.76 4,560
Accounts receivable 70,000 0.76 53,200
Cash 89,000 0.76 67,640
Accounts payable (98,000) 0.76 (74,480)
Tax payable (20,000) 0.76 (15,200)
Net assets 384,000 291,840

60
Illustration 2:
Translation Example
Statement of Financial Position at 31.12.20x1 (continued)
FC Rate $
Share capital 300,000 0.81 243,000
Retained earnings 84,000 From P/L 66,730
Foreign Currency Translation
Reserve Bal. fig. (17,890)
 Total Equity 384,000   291,840

• Two ways of determining the translation loss of $17,890

 Balancing figure as shown above
 Reconciliation check (or proof of translation gain or loss)

61
Illustration 2:
Translation Example
• Reconciliation check (or proof of translation gain or loss)

Exposed Items FC Rate $

Net assets b/f 332,000 0.81 268,920

Increase in net assets:
Net profit after tax 77,000 0.78 60,060
Decrease in net assets:
Dividend paid (25,000) 0.77 (19,250)
Net assets c/f 309,730 (A)
384,000 0.76 291,840 (B)

Translation difference for the year (B – A) (17,890)

62
Illustration 2:
Translation Example
Remeasured Profit & Loss Account (functional currency is $)
FC Rate $
Sales 600,000 0.78 468,000
COGS (380,000) Note 1 (299,000)
Gross profit 220,000 169,000
Depreciation (33,000) 0.81 Note 2 (26,730)
Insurance expense (12,000) 0.81 Note 3 (9,720)
Operating expenses (78,000) 0.78 (6,840)
Remeasurement loss Note 4 10
Profit before tax 97,000 71,720
Taxation (20,000) 0.78 (15,600)
Profit after tax 77,000 56,120
Dividend paid (25,000) 0.77 (19,250)
Retained profit for year 52,000 36,870
Retained profit b/f 32,000 0.81 25,920
Retained profit c/f 84,000   62,790

63
Illustration 2:
Translation Example
Note 1 – COGS      
  FC Rate $
Opening inventories 60,000 0.81 48,600
Purchases 400,000 0.78 312,000
Closing inventories (80,000) 0.77 (61,600)
COGS 380,000   299,000

Note 2 – Depreciation expense    

Depreciation expense is translated at the related fixed asset’s historical rate.
Similarly, amortization expense (if any) is also translated at related intangible
assets historical rate

Note 3 – Insurance expense    

Insurance expense is amortized from prepaid insurance arising as at
31.12.20x0

64
Illustration 2:
Translation Example
Note 4: Remeasurement loss
Exposed item FC Rate S$
Net monetary liabilities b/f (36,000)1 0.81 (29,160)
∆ in monetary assets/liabilities:
Sale 600,000 0.78 468,000
Purchases (400,000) 0.78 (312,000)
Operating expenses (78,000) 0.78 (60,840)
Taxation (20,000) 0.78 (15,600)
Dividend paid (25,000) 0.77 (19,250)
31,150 (A)
Net monetary assets c/f 41,0002 0.76 31,160 (B)
Remeasurement gain (B–A) 10

65
Illustration 2:
Translation Example
1 Opening exposed monetary items:
FC
Accounts Receivable 50,000
Cash 14,000
Accounts payable (100,000)
Net monetary item (36,000)

2 Closing exposed monetary items:

Accounts receivable 700,000
Cash 89,000
Accounts payable (98,000)
Tax payable (20,000)
Net monetary item c/f 41,000

66
Illustration 2:
Translation Example
Mango Pie
Statement of Financial Position at 31.12.20x1
FC Rate $
Fixed assets (net) 257,000 0.81 208,170
Inventories 80,000 0.77 61,600
Prepaid insurance 6,000 0.81 4,860
Accounts receivables 70,000 0.76 53,200
Cash 89,000 0.76 67,640
Accounts payables (98,000) 0.76 (74,480)
Tax payables (20,000) 0.76 (15,200)
Net assets 384,000 305,790
 
Share capital 300,000 0.81 243,000
Retained earnings 84,000 From P/L 62,790
  384,000   305,790

67
Content

1. Introduction
2. Types of Foreign Exchange Rate Management Regimes
3. How Exchange Rates Are Quoted
4. Spot and Forward Rate
5. Types of Foreign Exchange Rate Exposures
6. Concept of Functional Currency
7. Foreign Currency Transactions of a Stand-alone Entity (IAS 21:20–26)
8. Translation of Foreign Currency Financial Statements
9.
9. SpecialIssues
Special Issues
10. Evaluation of Translation Approaches

68
Goodwill Arising from the Acquisition of
Foreign Subsidiaries
Goodwill (GW), as an asset, belongs to whom?

If GW is an asset of the acquire If GW is an asset of the acquirer

(the foreign operation) (parent)

Need to be translated No translation required

• IAS 21 Para 47 states that goodwill arising on acquisition of foreign operation shall
be treated as assets of the foreign operation

• If functional currency of the foreign operation is the local currency:

 Goodwill translated at the closing rate
If functional currency of foreign operation is parent’s currency:
 Goodwill treated as non-monetary assets and remeasured at exchange rate at
acquisition date
69
Equity Accounting for Foreign Associates

• Associated companies are more likely to be autonomous entities

– Associate’s functional currencies are likely to be the local currency
– Associate’s financial statements are first translated to investor’s
presentation currency using closing rate method
– Equity accounting is applied subsequently
 Need to allocate investor’s share of the cumulative FCTR

70
Change of Functional Currency

• A change of functional currency might be due to a change:

– In primary economic environment
– In the nature of operating relationship between the foreign operation and the
parent

• Functional currency change is implemented prospectively

– No restatement of prior year financial statements
Functional currency is changed
Year ended translation procedure
From To

Local currency Parent’s currency • Apply remeasurement procedures

• Cumulative translation differences remain in equity
until disposal
• Non-monetary assets are translated at the rate on
the date when the change is effected
Parent’s currency Local currency • All assets and liabilities are translated at closing
rate
• Translation differences are taken to equity 71
Change of Functional Currency
• IAS 21 para 37 requires all assets and liabilities to be translated into the new
functional currency using exchange rate at the date of change

• New translated amount of a non-monetary assets becomes its new historical cost and
gives rise to:
– Revised depreciation / amortization / cost of sales expense in subsequent period

• Example: Functional currency of company is changed from dollar (parent’s currency)

to the local currency (LC)
Previously ($) Revised (LC)
Fixed assets 1,000,000 1,500,000
Monetary net assets 200,000 300,000
Net assets 1,200,000 1,800,000
Share capital 500,000 750,000
Retained earnings 700,000 1,050,000
Equity 1,200,000 1,800,000
72
Exchange Differences Arising from
Intercompany Transactions
• Intercompany transactions are normally denominated in either the parent’s currency
or the subsidiary’s currency
– Results in translation gain or loss recorded by one party
– Translation gain or loss is not eliminated as they are one sided

• Long term loan from parent

– Considered as part of parent’s net investment in the subsidiary
– E.g. Interest free loan, loan with no definite or scheduled payment
– IAS 21 Para 32 requires exchange difference to be reclassified to equity (FCTR)
– However, the loan classification is not affected
– Reclassification journal entries is:

Dr Exchange gain on loan (IS) Dr FCTR (equity)

Cr FCTR (equity) Cr Exchange loss on loan (IS)

73
Exchange Differences Arising from
Intercompany Transactions
Monetary item In foreign In
Nature of In parent’s
denominated operation’s Consolidated
monetary item book
in: books accounts
Records
No exchange exchange
Parent’ difference is difference on
functional recorded monetary item
currency in IS
Records
Foreign exchange No exchange
operation’s difference on difference is Exchange
Forms part of difference on
parent’s net currency monetary item recorded
in IS monetary item
investment in is reclassified to
the foreign Records Records equity (FCTR)
operation exchange exchange
difference on difference on
3rd currency monetary item monetary item
in IS in IS

74
Exchange Differences Arising from
Intercompany Transactions
Monetary item In foreign In
Nature of In parent’s
denominated operation’s Consolidated
monetary item book
in: books accounts
Records
No exchange exchange
Parent’s difference is difference on
functional recorded monetary item
currency in IS
Records
Foreign exchange No exchange
operation’s difference on difference is
Is not part of currency monetary item recorded Flows through
parent’s net in IS to consolidated
investment Records Records IS
exchange exchange
difference on difference on
3rd currency monetary item monetary item
in IS in IS

75
Carrying Value of Inventories

• Inventory is carried at lower of cost or net realizable value

• If Inventory is measured in a foreign currency:
– Reported carrying value is the lower of:
 Inventory cost (foreign currency) X Actual (historical) rate
 Inventory at NRV (foreign currency) X Closing rate

76
Foreign Operation in a Hyperinflationary
Environment
• Indicators of a hyperinflationary economy:
– Inflation rate of 100% or more over a period of 3 years;
– Interest rates, wages and prices that are linked to a price index;
– Prices that are quoted in a stable currency; and
– A general population that prefers to keep its wealth in non-monetary assets
or in a stable currency

• Financial statements that are not adjusted for inflation are not useful (IAS 29)
– Misleading to compare transactions that occurred at different times due to
loss of purchasing power at a rapid rate

• IAS 21 requires a restate-then-translate approach

– Financial statements for the current and previous periods are stated at the
measuring unit current at the end of the reporting period (IAS 29)
– All amounts are translated at closing rate at the date of the most recent
balance sheet date
77
Content

1. Introduction
2. Types of Foreign Exchange Rate Management Regimes
3. How Exchange Rates Are Quoted
4. Spot and Forward Rate
5. Types of Foreign Exchange Rate Exposures
6. Concept of Functional Currency
7. Foreign Currency Transactions of a Stand-alone Entity (IAS 21:20–26)
8. Translation of Foreign Currency Financial Statements
9. Special Issues
10. EvaluationofofTranslation
10. Evaluation Translation Approaches
Approaches

78
Evaluation of Translation Approaches
• Objective of translation under SFAS 52 in USA:
1. Provide information that is generally compatible with the expected
economic effects of a rate change on the enterprise’s cash flow and equity;
and
2. Reflect in the consolidated statements the financial results and
relationships of the individual consolidated entities measured in their
functional currencies

• Evaluate the closing rate method against the above objectives:

 An appreciation in the foreign operation currency will result in a translation
gain and a loss when the currency depreciates (1st objective)
 Financial relationships among items in the original financial statements are
preserved (2nd objective)
 A serious flaw is that the translated balances sheets are measured neither
at historical nor current value  rendering figures meaningless in
accounting terms
79
Evaluation of Translation Approaches

• Evaluate the remeasurement method against the objectives:

– Distorts the original financial ratios  hampers proper performance
evaluation
– However, it is argued that if foreign operation’s functional currency is the
same as the parent’s functional currency:
 Then the original financial statements do not express the financial
results and relationships in its functional currency
– Therefore, this method attempts to “put thing right” as though the foreign
operation had been conducted in the parent’s functional currency

80