1. Connolly – International Financial Accounting and Reporting – 4 th Edition CHAPTER 31 FOREIGN CURRENCY TRANSACTIONS AND TRANSLATION OF FOREIGN OPERATIONS

2. Connolly – International Financial Accounting and Reporting – 4 th Edition 31.1 INTRODUCTION Exchange rates effect competitiveness A strong / weak currency impacts on exports and imports There is arguably no one best position – it depends on the nature of your business Businesses that deal in a foreign currency are exposed to risks IAS 21 The Effects of Changes in Foreign Exchange Rates IAS 29 Financial Reporting in Hyperinflationary Economies

3. Connolly – International Financial Accounting and Reporting – 4 th Edition IAS 21 The Effects of Changes in Foreign Exchange Rates Objective and Scope To set down the manner in which foreign currency transactions should be brought to account To set down the manner in which the financial statements of foreign operations should be translated for inclusion in the enterprise’s financial statements by consolidation, proportionate consolidation or by the equity method

4. Connolly – International Financial Accounting and Reporting – 4 th Edition Key definitions Functional Currency The currency of the primary economic environment in which the enterprise operates. Presentation Currency The currency in which an enterprise presents its financial statements. Closing Rate This is the spot exchange rate at the reporting date. Exchange Difference This is the difference resulting from translating one currency into another currency at different exchange rates. Monetary and Non Monetary Items Monetary items are assets/liabilities held to be received/paid in fixed or determinable amounts. Examples include deferred tax, pensions and provisions. The feature of a non-monetary item is the absence of a right to receive a fixed or determinable amount of money (this includes prepayments, goodwill, intangible assets, inventory and property).

5. Connolly – International Financial Accounting and Reporting – 4 th Edition 31.2 Foreign Currency Transactions Initial Recognition  Each transaction should be translated using the ER on the date the transaction occurred, or if stable, an average rate  If certain transactions are to be settled at a specified rate, or are covered by a matching forward contract, then the use ‘contracted rate’ Reporting at Subsequent Reporting Dates  Monetary items at closing ER (e.g. trade receivables and payables)  Non-monetary items measured at HC are not re-translated at the reporting date (e.g. non-current assets and inventory)  Non-monetary items measured at foreign currency fair value are re-translated at each date of fair value measurement

6. Connolly – International Financial Accounting and Reporting – 4 th Edition Recognition of exchange differences Those arising on settlement of monetary items should be expensed in the period they arise Where a gain/loss on a non-monetary item is recognised directly in equity any exchange component of that gain/loss should be recognised directly in equity Conversely when a gain/loss on a non-monetary item is recognised in profit or loss, any exchange component of that gain/loss should be recognised in profit or loss. If a transaction is settled before the end of a reporting, then: (i) record the foreign currency transaction in the functional currency at the spot exchange rate at the date of the transaction (an average rate for a period may be used if exchange rates do not fluctuate significantly); (ii) record the settlement at the exchange rate at the date of settlement; (iii) recognise the exchange difference (i.e. (i) minus (ii) in arriving at operating profit in the statement of comprehensive income).

7. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 31.1: Transactions settled at the reporting date Blue Limited, whose year end is 31 December, buys goods from a foreign company for 180,000 Ricos on 31 July 2013. The transaction is settled on 31 October 2013. Exchange rates: 31 July 2013 €1 = 1.5 Ricos 31 October 2013 €1 = 1.6 Ricos Requirement Show the journal entries to record the above transaction.

8. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 31.1: Transactions settled at the reporting date Initial recognition: DrSPLOCI – P/L – purchases€120,000 CrSFP – trade payables €120,000 Being initial recognition of goods purchased on credit (180,000 Ricos / 1.5) At settlement: DrSFP – trade Payables €120,000 Cr SPLOCI – P/L – Fx Gain (e.g. CoS)€7,500 Cr SFP – Cash €112,500 Being settlement and recognition of exchange difference

9. Connolly – International Financial Accounting and Reporting – 4 th Edition Transactions not settled at the reporting date If a transaction is not settled before the end of a reporting, then: (i) record the transaction (in the functional currency) at the spot exchange rate at the date of the transaction; (ii) retranslate any monetary items; (iii) recognise any exchange difference in arriving at profit or loss in SPLOCI.

10. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 31.2: Transactions not settled at the reporting date Top Limited buys goods from a foreign company for 500,000 Zicos on 31 October 2012. The transaction was not settled at 31 December 2012, the company’s year end. Exchange rates: 31 October 2012 €1 = 1.6 Zicos 31 December 2012 €1 = 1.75 Zicos Requirement Show the journal entries to record the above transaction.

11. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 31.2: Transactions not settled at the reporting date Initial recognition: DrSPLOCI – P/L – purchases €312,500 Cr SFP – trade payables €312,500 Being initial recognition of goods purchased on credit (500,000 Zicos / 1.6) At the reporting date: Dr SFP – trade payables €26,786 Cr SPLOCI – P/L – Fx Gain €26,786 Being translation of payable at reporting date and recognition of exchange difference

12. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 31.3: Purchase of a non-monetary item A company purchased a property on 1 January 2013 for 20,000 DM (when €1 = 4DM), with the account being settled on 1 March 2013 when the exchange rate was 20,000 DM = €5,500. If the company’s year end is after 1 March 2013, then this transaction should be recorded as follows: At 1 January 2013: Dr SFP – property €5,000 Cr SFP – payables €5,000 Being initial recognition of property At 1 March 2013: Dr SPLOCI – P/L – Fx Loss€500 Dr SFP – payables €5,000 Cr Bank €5,500 Being settlement of liability and recognition of exchange difference

13. Connolly – International Financial Accounting and Reporting – 4 th Edition Example 31.3: Purchase of a non-monetary item However, if the company’s year end is 31 January 2013, and at 31 January 2013 20,000 DM = €4,900, then: At 31 January 2013: DrSFP – payables€100 CrSPLOCI – P/L – exchange gain€100 31 January 2013: DrSFP – payables€4,900 DrSPLOCI – P/L - exchange loss€600 CrSFP – bank€5,500

14. Connolly – International Financial Accounting and Reporting – 4 th Edition REVIEW QUESTION 31.1

15. Connolly – International Financial Accounting and Reporting – 4 th Edition 1. Review Question 1 – MANCO Limited €€ DRCash571,429 CRLoan Account571,429 - Being US $1m loan received at $1.75/€ DRLoan Account15,873 CRSPLOCI – P/L – FX gain15,873 - Being FX gain on YE retranslation of $1m at $1.80/€ 2. DRPPE17,460 CRPayables – Frtz17,460 - Being purchase of PPE DM55,000 at DM3.15/€ DRSPLOCI – P/L – depreciation1,746 CRAccumulated Depreciation1,746 - Being 6 months depreciation at 20% pa DRPayables – Frtz17,460 DRSPLOCI – P/L – FX loss873 CRBank and cash18,333 - Being payment for PPE DM55,000 at DM3/€

16. Connolly – International Financial Accounting and Reporting – 4 th Edition 3.€€ DRPurchases8,824 CRPayables – Etien8,824 - Being BFr600,000 purchases at BFr68/€ DRPayables – Etien191 CRSPLOCI – P/L – FX gain191 - Being FX gain on YE retranslation of BFr600,000 at bfR69.5/€ SPLOCI – Ye 31 March 2013€ Included in arriving at PBT: FX gains and (losses) (€15,873 - €873 + €191)15,191 Depreciation PPE(1,746) SFP as at 31 March 2013€ Non Current Assets: PPE (NBV)15,714 Current Assets: Bank and cashxxxxx Current Liabilities / Non Current Liabilities: Loan(555,556) Current Liabilities: Trade Payables(8,633)

17. Connolly – International Financial Accounting and Reporting – 4 th Edition 31.3 FOREIGN CURRENCY TRANSLATION Should follow normal consolidation procedures (See Chapters 26-28). IAS 27 permits the use of different reporting dates as long as they are no more than three months apart and adjustments are made for the effects of any significant transactions between those dates. In such cases, the exchange rate to adopt is that at the reporting date of the foreign operation. IAS 21 shows how to translate FS into a presentation currency (i.e. the currency in which the FS are presented. This contrasts with the functional currency, which is the currency of the primary economic environment in which the (foreign) entity operates. Depending upon the relationship between the parent and the subsidiary companies, the presentation currency and the functional currency may or may not be the same.

18. Connolly – International Financial Accounting and Reporting – 4 th Edition Normal consolidation procedures Eliminate IC balances Need to translate I/C monetary balances Goodwill treated as asset of foreign operation and translated at CR

19. Connolly – International Financial Accounting and Reporting – 4 th Edition Presentation currency = Functional currency SAME FUNCTIONAL CURRENCY: i.e. Foreign trade conducted as a direct extension of investing company Decision depends upon: Extent to which foreign cash flows have a direct impact upon those of the investing company Extent to which the functioning of the enterprise is dependent directly upon the investing company Currency in which the majority of the trading transactions are denominated Major currency to which the operation is exposed Specific circumstances: Acts as a selling agent Merely a producer/manufacturer Located overseas for tax or exchange control reasons

20. Connolly – International Financial Accounting and Reporting – 4 th Edition Presentation currency = Functional currency The translation mechanics are: Non-monetary assets (e.g. PPE and inventory) translated at historical rate (Cost or Revaluation) Monetary assets and liabilities (e.g. receivables and payables) translated at CR OSC and pre-acquisition reserves at historic rate (i.e. ‘acquisition rate’) Post-acquisition reserves are a balancing figure SPLOCI translated using ER ruling at the dates the amounts recorded in the financial statements were established (e.g. Depreciation - Historic Rate) All other items - Average Rate If available, use rates specific to opening and closing inventory Exchange difference included in PBT in the SPLOCI – P/L

21. Connolly – International Financial Accounting and Reporting – 4 th Edition Presentation currency ≠ Functional currency Indicators are: Investment based on net worth of foreign entity May be partly financed by local currency loans Day-to-day operations of foreign entity are not dependent on holding company’s currency Net investment will remain until business is liquidated or disposed

22. Connolly – International Financial Accounting and Reporting – 4 th Edition Presentation currency ≠ Functional currency The translation mechanics are: Assets & liabilities translated at the year-end rate (i.e. CR) OSC and pre-acquisition reserves at historic rate (i.e. ‘acquisition rate’) Post-acquisition reserves are a balancing figure Compare difference between closing reserves and opening reserves with translated retained earnings to obtain exchange difference Exchange differences taken directly to reserves (separate component) SPLOCI translated using AR Exchange difference will arise from:  Retranslating the opening NA at CR  Translating SPLOCI at AR and SFP at CR

23. Connolly – International Financial Accounting and Reporting – 4 th Edition Foreign exchange differences Presentation Currency = Functional Currency: Exchange differences should be recognised in the SPLOCI – P/L. Presentation Currency ≠ Functional Currency (Presentation Currency Method): All exchange differences should be recognised in equity as a separate component (through OCI). Foreign exchange differences arise from: 1.Translating income and expenses at the transaction rate and assets/liabilities at the CR; 2.Translating opening net assets at an exchange rate different from that previously reported; 3.As any goodwill and fair value adjustments should be treated as assets and liabilities of the foreign operation, they therefore must be expressed in the functional currency of the foreign operation and translated at the CR. If a foreign operation is not 100% owned by the parent company, then exchange differences should be allocated to NCI.

24. Connolly – International Financial Accounting and Reporting – 4 th Edition Disposal of foreign entity Cumulative exchange differences should be recognised as income or expenses in the same period as the gain or loss on disposal is recognised

25. Connolly – International Financial Accounting and Reporting – 4 th Edition Disclosure 1.The amount of exchange differences included in arriving at profit or loss in the SPLOCI except those arising from IAS 39; 2.Net exchange differences classified as a component of equity and a reconciliation of opening and closing equity at start and end of the year; 3.When the presentation currency is different from the functional currency, that fact should be disclosed as well as disclosure of the functional currency and the reason for using a different presentation currency; 4.When there is a change in the functional currency of either the reporting entity or a significant foreign operation, that fact and reason for the change should be disclosed; 5.When an entity presents its financial statements in a currency different from its functional currency, it should describe the statements as complying with IFRSs only if they comply with all of the requirements of each applicable standard and SIC. Where the requirements listed at item 5. above are not met an entity should: clearly identify the information as supplementary; disclose the currency in which the supplementary information is displayed; disclose the entity’s functional currency and method of translation used to determine the supplementary information.

26. Example 31.4: Translation of a foreign subsidiary

27. Connolly – International Financial Accounting and Reporting – 4 th Edition FUNCTIONAL CURRENCY # PRESENTATION CURRENCY Quickbuck Limited 1. SPLOCI TRANSLATED USING AR$ER€ Revenue544,2754136,069 Cost of sales(145,000)4(36,250) Gross profit399,27599,819 Depreciation(30,000)4(7,500) Other expenses(271,050)4(67,762) PBT98,22524,557 Income tax expense(24,275)4(6,069) PAT73,95018,488 OCI: FX losses(W5(b))(3,198) 15,290

28. Connolly – International Financial Accounting and Reporting – 4 th Edition 2. A & L TRANSLATED USING CR 3. OSC TRANSLATED USING HR 4. RE AS BALANCING FIGURE$ER€ PPE270,000554,000 Inventory48,52559,705 Receivables45,50059,100 Bank and cash 9,4755 1,895 373,50074,700 Ordinary share capital75,000325,000 RE & FC translation reserve (should be shown separately)70,450Balance (W6)4,090 Loan90,000518,000 Payables103,775520,755 Taxation24,27554,855 Proposed dividends 10,0005 2,000 373,50074,700

29. Connolly – International Financial Accounting and Reporting – 4 th Edition 5. CALCULATE FX DIFFERENCE$ER€ (a) Opening NA at OR [Prior year CR] Ordinary share capital [No change]75,000325,000 Retained earnings [$70,450 - $53,950]16,500(Balance) 5,500 91,500330,500 Opening NA at CR91,500518,300 12,200 (b) Translate RE [SPLOCI at AR v SFP at CR) PAT [See SPLOCI]73,950418,488 Dividends paid [Per Q](10,000)4(2,500) Dividends proposed(10,000)5(2,000) RE per SPLOCI [mainly at AR]53,95013,988 RE per SFP [at CR]53,9505(10,790) Taken through OCI [W1 €18,488 - €3,198 = €15,290]3,198 (c) TOTAL FX LOSS (Separate component of equity)15,398

30. Connolly – International Financial Accounting and Reporting – 4 th Edition 6. MOVEMENT ON RETAINED EARNINGS€ Opening RE at 1 January 2012(See w5a)5,500 Retained profit for year(See w5b)13,988 19,488 FX loss (to be presented separately)(See w5c)(15,398) Closing RE at 31 December 2012(See w4)4,090

31. Connolly – International Financial Accounting and Reporting – 4 th Edition FUNCTIONAL CURRENCY = PRESENTATION CURRENCY Quickbuck Limited 1. TRANSLATE SFP Non monetary at HR Monetary A&L at CR$ER€ PPE270,0002.5108,000 Inventory48,5254.810,109 Receivables45,50059,100 Bank and cash 9,4755 1,895 373,500129,104 Ordinary share capital75,000325,000 Retained earnings70,450(Balance)58,494 Loan90,000518,000 Payables103,775520,755 Taxation24,27554,855 Proposed dividends 10,0005 2,000 373,500129,104

32. Connolly – International Financial Accounting and Reporting – 4 th Edition FUNCTIONAL CURRENCY = PRESENTATION CURRENCY 2. SPLOCI TRANSLATED USING ER RULING AT DATES AMOUNTS RECORDED IN FS$ER€ Revenue544,2754136,069 Opening inventory Purchases Closing inventory Cost of sales 41,000 152,525 (48,525) 145,000 3 4 4.8 13,667 38,131 (10,109) 41,689 Gross profit399,27594,380 Depreciation(30,000)2.5(12,000) Other expenses(271,050)4(67,762) FX gain -(W3(b))28,945 PBT98,22543,563 Income tax expense(24,275)4(6,069) PAT73,95037,494

33. Connolly – International Financial Accounting and Reporting – 4 th Edition 3. CALCULATE EXCHANGE DIFFERENCE$ER€ (a) Translate opening SFP Ordinary share capital75,000325,000 Retained earnings [$70,450 - $53,950]16,500(Balance) 25,500 91,50050,500 PPE300,0002.5120,000 Inventory41,000313,667 Net monetary liabilities (to balance)(249,500)3(83,167) 91,50050,500 (b) Opening RE (see above)25,500 + profit for year (PAT €8,549 – divs. Paid €2,500 – divs. Prop €2,000)4,049 Closing RE per SFP(58,494) FX gain (include in SPLOCI – P/L)28,945