1. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–1 Chapter 31 Accounting for foreign currency transactions

2. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–2 Objectives Understand why it is necessary to translate foreign currency transactions into Australian dollars Understand that all transactions denominated in overseas currencies must initially be translated at the exchange rate in place as at the date of the transaction (the transaction date’s spot rate) (continues)

3. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–3 Objectives (cont.) Understand that at balance date all foreign currency monetary items must be translated at the balance- date spot rate, and that apart from two exceptions (relating to hedges of specific commitments and qualifying assets), the movements in the value of foreign currency monetary items are to be treated as part of the financial period’s profit or loss (continues)

4. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–4 Objectives (cont.) Understand what a qualifying asset is and be able to provide the appropriate accounting entries relating to a qualifying asset Understand the difference between a general hedge and a hedge of a specific commitment, and be able to provide the appropriate accounting entries in respect of both (continues)

5. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–5 Objectives (cont.) Understand what a foreign currency swap is and why it might be undertaken, and be able to provide the relevant journal entries to account for a foreign currency swap

6. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–6 Introduction to accounting for foreign currency transactions Accounting for foreign currency transactions is governed by AASB 121 ‘The Effect of Changes in Foreign Exchange Rates’ Australian companies now allowed to use ‘presentation currency’ (currency in which the financial report is prepared) in other than Australian dollars, but must disclose the reason and justification for its choice of presentation currency (continues)

7. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–7 Introduction to accounting for foreign currency transactions (cont.) Two general issues to be considered in foreign currency translations: 1. Where debts, receivables or other monetary items are denominated in currencies other than domestic currency there is a need to convert them into a single currency (not necessarily Australian dollars) – Unless transactions converted into a common currency, financial statements would include account balances in different currencies 2. Where an entity controls a foreign subsidiary, the accounts of that subsidiary need to be translated into a common currency before the consolidation process (addressed in Chapter 32)

8. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–8 Foreign currency transactions Exchange rate defined as (AASB 121): – the ratio of exchange for two currencies Exchange rates frequently change (daily) and this results in the need for the translation of transactions. This involves transactions: – denominated in a foreign currency; or – requiring settlement in a currency other than the functional currency of the entity. (continues)

9. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–9 Foreign currency transactions (cont.) Examples of foreign currency transactions Acquisition of goods from a foreign supplier where the transaction is denominated in a foreign currency Sale of goods to a foreign customer where the transaction is denominated in a foreign currency Loan from foreign lender denominated in a foreign currency Refer to Worked Example 31.1 on page 1041—Acquisition of goods from a foreign supplier where the transaction is denominated in a foreign currency (continues)

10. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–10 Foreign currency transactions (cont.) Accounting entry at date of original transaction AASB 121 (par.21) 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 Key terms Spot exchange rate: the exchange rate for immediate delivery Functional currency: the currency of the primary economic environment in which the entity operates—important as this identifies what currency the transactions will be converted into (continues)

11. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–11 Foreign currency transactions (cont.) Key terms (cont.) Functional currency—note AASB 121 (par. 9) The primary economic environment in which an entity operates is normally the one in which it primarily generates and expends cash. An entity considers the following factors in determining functional currency: (a) the currency: (i) that mainly influences sales prices for goods and services (this will often be the currency in which sales prices for its goods and services are denominated and settled): and (ii) of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services. (b) The currency that mainly influences labour, material and other costs of providing goods and services (this will often be the currency in which such costs are denominated and settled) (continues)

12. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–12 Foreign currency transactions (cont.) Key terms (cont.) Presentation currency—the currency in which the financial report is presented—note AASB 121 (par. 38): – An entity may present its financial report in any currency (or currencies). If the presentation currency differs from the entity’s functional currency, it translates it results and financial position into the presentation currency. For example, when a group contains individual entities with different functional currencies, the results and financial position of each entity are expressed in a common currency so that a consolidated financial report may be presented (continues)

13. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–13 Foreign currency transactions: reporting date adjustments Foreign currency monetary items outstanding at the reporting date must be translated using the closing rate – Closing rate—the spot exchange rate at the reporting date – Foreign currency monetary items—include accounts payable and receivable; cash; interest, notes, loans and dividends receivable; bank overdraft; income taxes, wages, notes and/or debentures payable Any exchange differences (foreign exchange gains or losses) are then brought to account in the profit and loss in the reporting period in which the exchange rates change (continues)

14. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–14 Foreign currency transactions: reporting date adjustments (cont.) Exception to rule that foreign currency monetary items outstanding at reporting date must be translated at spot rate at reporting date: – Instances of contractual arrangement—the exchange rate has been fixed for a particular transaction General principle applied, however, is that exchange differences relating to monetary items are to be recognised as income or expenses in reporting period in which the exchange rates change – Exceptions to this rule (addressed later): ▪ qualifying assets ▪ certain types of hedges

15. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–15 Determination of functional currency and presentation currency Number of issues to consider in determining functional currency (AASB 121, par. 9): – Consideration needs to be given to the currency in which the general purpose financial report is prepared ▪ If the entity’s shareholders reside primarily within Australia the expectation is that the presentation currency would be Australian dollars (continues)

16. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–16 Determination of functional currency and presentation currency (cont.) Number of issues to consider in determining functional currency (AASB 121, par. 9) (cont.): – Presentation currency may not be the same as functional currency, e.g. parent company residing in Australia controls a subsidiary company residing in a foreign country (e.g. South Africa) ▪ If subsidiary operates within South Africa and sells its goods and purchases its raw materials in Rand, the functional currency is South African rands ▪ For the purposes of translating the results for Australian purposes, the presentation currency would be Australian dollars Refer to Worked Example 31.2 on page1044—Determination of functional currency and presentation currency

17. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–17 Long-term receivables and payables At balance date all monetary items must be translated using the reporting-date spot rates Exchange gain or loss that results from translating both current and non-current receivables and payables must be included in the operating profit or loss for the financial period – Unpopular with Australian companies as fluctuations mean there is doubt as to whether unrealised profit/loss will actually be realised, particularly in relation to non-current monetary items – Argued that recognition of a profit or loss at reporting date is inappropriate, since the exchange rate fluctuates in the long term and there is significant doubt whether the unrealised profit or loss will ever be realised Refer to Worked Example 31.3 on pp. 1045–6—Translation of a non-current liability

18. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–18 Translation of other monetary assets such as cash deposits The same principles apply to translation of other monetary items such as cash and money market deposits Refer to Worked Example 31.4 on page 1046— Translation of cash denominated in a foreign currency

19. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–19 Qualifying assets Exception to the general rule that exchange differences relating to monetary items (current and non-current) are to be brought to account as expenses or revenues in the period in which the exchange rate changes Defined in AASB 123 ‘Borrowing Costs’ as an asset that necessarily takes a substantial period of time (considered to be greater than 12 months) to get ready for its intended use or sale (continues)

20. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–20 Qualifying assets (cont.) Examples (AASB 123, par. 6) – Inventories that require a substantial period of time to bring them to a saleable condition, manufacturing plants, power generation facilities and investment properties. – Other investments, and those inventories that are routinely manufactured or otherwise produced in large quantities on a repetitive basis over a short period of time, are not qualifying assets. Assets that are ready for their intended use or sale when acquired are also not qualifying assets. (continues)

21. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–21 Qualifying assets (cont.) Exchange differences that lead to an increase in the cost of an asset are considered to be borrowing costs under AASB 123 For qualifying assets, AASB 123 allows the borrowing costs to either: – be capitalised as part of the cost of the asset (borrowing costs that are directly attributable to acquisition, construction or production of a qualifying asset shall be capitalised as part of the cost of that asset, par. 11); or – included in the calculation of profit (as an expense or revenue item). (continues)

22. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–22 Qualifying assets (cont.) Exchange differences included in cost of qualifying assets for the financial year are the amounts that would otherwise have been credited/debited to income statement Amount capitalised as the cost of the asset not to exceed its recoverable amount If exchange differences cause the recoverable amount of a qualifying asset to be exceeded, the excess should be written off to the income statement (AASB 123, par. 19) Refer to Worked Example 31.5 on page 1048— Foreign currency transaction relating to a qualifying asset

23. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–23 Hedging transactions Where amounts are owed to or owed by entities in foreign currencies, entities are exposed to the risk of losses, which might be generated by movements in exchange rates To minimise the risk associated with foreign currency monetary items, an entity may enter a hedging contract (continues)

24. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–24 Hedging transactions (cont.) Hedging – Action taken, whether by entering a foreign currency contract or otherwise, with the objective of avoiding or mitigating possible adverse financial effects of movements in exchange rates – Agreement entered into that takes a position opposite to the original transaction AASB 121 does not address foreign currency hedges Need to refer to AASB 139 ‘Financial Instruments: Recognition and Measurement’ (continues)

25. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–25 Hedging transactions (cont.) Buy hedge Involves a situation where a third party (eg bank) agrees to sell a fixed amount of a particular overseas currency on a fixed future date at the rate of exchange quoted in the contract (the forward rate) Useful to entities that buy goods with the purchase price denominated in a foreign currency Forward rate - the exchange rate for delivery of a currency at a specified date in the future i.e. a guaranteed rate of exchange that will be provided in the future (continues)

26. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–26 Hedging transactions (cont.) Sell hedge Arrangement to sell an overseas currency to another entity, on or before a particular date, at an agreed rate Useful to an entity that sells goods overseas with the sales price denominated in a foreign currency An Australian entity can fix at the outset the amount of Australian dollars it will ultimately receive from a sale (continues)

27. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–27 Hedging transactions (cont.) When there is a hedge, the foreign exchange gains or losses on one transaction (e.g. hedge contract) will be offset by gains or losses on another (e.g. transaction with a purchaser of the entity’s inventory) If the exchange rate falls, a gain will be made on the sale to overseas purchaser but a loss will be made on the contract with the bank because the overseas currency has increased in value—the entity had already agreed to a forward rate with the bank If the exchange rate rises (in the same scenario) the opposite will hold Perfectly hedged—hedge agreement completely eliminates the consequences of adverse exchange rate fluctuations—otherwise, partially hedged (continues)

28. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–28 Hedging transactions (cont.) Accounting for hedge transactions Hedge accounting Recognises the offsetting effects on profit or loss of changes in the fair values of the hedging instrument and the hedged item (AASB 139, par. 85) Hedge instrument 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 of cash flows of a designated hedge item (pars 72–7 and Appendix A pars AG94–AG97 elaborate on the definition of a hedging instrument) (continues)

29. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–29 Hedging transactions (cont.) Accounting for hedge transactions (cont.) Hedge item An asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation that (a) exposes the entity to risk in changes of fair value or future cash flows and (b) is designated a hedge (pars 78–84 and Appendix A pars AG98–AG101 elaborate on the definition of hedged items) Hedge accounting Attempts to match the timing of the profit or loss recognition on the hedging instrument with the profit and loss on the hedged item—only when the hedging instrument meets specific requirements To classify an arrangement as a hedge and to apply ‘hedge accounting’ AASB 139 strictly requires five conditions to be met (continues)

30. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–30 Hedging transactions (cont.) Five conditions to be met to apply ‘hedge accounting’ (AASB 139, par. 88): 1. At the inception of the hedge there is a formal designation and documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge 2. The hedge is expected to be highly effective (Appendix A, pars AG105-AG113) in achieving offsetting changes in fair values or cash flows attributable to the hedge risk 3. For cash flow hedges, a forecast transaction that is the subject of the hedge must be highly probable and must present an exposure to variations in cash flows that could ultimately affect profit or loss 4. The effectiveness of the hedge can be reliably measured, i.e. the the fair value or cash flows of the hedged item that are attributable to the hedged risk and the fair value of the hedging instrument can be reliably measured 5. The hedge is assessed on an ongoing basis and determined actually to have been highly effective throughout the reporting periods for which the hedge was designated (continues)

31. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–31 Hedging transactions (cont.) Accounting for hedge transactions (cont.) Five conditions summarised in Figure 31.1 (p. 1052) If conditions not satisfied hedge accounting is not be be applied Two tests to be applied concerning ‘hedge effectiveness’ 1. Prospectively, at the inception of the hedge and throughout the life of the hedge, the hedge must be ‘highly effective’, i.e. the changes in the fair value or the cash flows of a hedged item (e.g. payable related to the purchase of inventory) must ‘almost fully’ offset the changes in the fair value or cash flows of the hedging instrument (e.g. forward-rate commitment with a bank) 2. Retrospectively, and as measured each financial period, the hedge is deemed to be highly effective so that the actual results are in a range of between 80 and 125%, e.g. if there is a gain on a hedging instrument of $100 and the loss on the hedged item is $110 the effectiveness of the hedge in terms of offsetting the loss on the hedged item is 100/110 (90.01%)—if the loss on the hedge item was $200 the test would not have been met (continues)

32. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–32 Hedging transactions (cont.) Accounting for hedge transactions (cont.) Three types of hedges identified in AASB 139: 1. Fair value hedges (not addressed in this chapter) 2. Cash-flow hedges (addressed in this chapter) 3. Hedges of net investments of foreign operations (not addressed in this chapter) Need to account for separately: the hedging transaction, e.g. forward rate agreement with a bank; and the transaction that led to the need for the hedge, e.g. original purchase or sales arrangement with an overseas entity (continues)

33. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–33 Hedging transactions (cont.) Accounting for hedge transactions (cont.) Hedges Those that relate to specific commitments—one that relates specifically to the purchase or sale of specific goods and services Those that do not relate to specific commitments Accounting for hedges not relating to specific commitments Any exchange differences on the hedge transactions undertaken to hedge foreign currency exposure shall be brought to account in the income statement in the financial year in which the exchange rates change (continues)

34. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–34 Hedging transactions (cont.) Accounting for hedges not relating to specific commitments (cont.) – Any costs or gains arising at the time of entering the hedge shall (hedge premium or discount), if material, be accounted for separately and be amortised to the income statement over the life of the hedge—this includes brokerage fees and any discounts or premiums on hedge contracts (i.e. difference between the exchange rate for immediate delivery of currencies to be exchanged (spot rate) and the forward rate when the contract was entered into) Refer to Worked Example 31.6 on pp. 1053–5—Adoption of a hedge contract after the date of the purchase of goods (continues)

35. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–35 Hedging transactions (cont.) Accounting for hedges relating to specific commitments For a transaction to be designated a hedge of a specific commitment it needs to meet the five tests previously identified If specific hedge relates to the price of particular goods or services to be purchased or sold—the gain or loss on hedging transaction up to the date of purchase or sale and any costs or gains arising at the time of entering into that transaction are (per AASB 139) deferred by recognising the amounts directly in equity When the underlying transaction is recognised (eg inventory actually acquired) the amounts are removed from equity and included in the measurement of the purchase price or as part of the sale transaction

36. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–36 Hedging transactions (cont.) Accounting for hedges relating to specific commitments (cont.) – Any hedge premium or discount is not deferred and amortised but adjusted against the cost or sales price of the goods or services Refer to Worked Example 31.7 on pp.1056–9 (Specific commitment) Refer to Worked Example 31.8 on pp. 1060–2 (Not a specific commitment) Refer to Worked Example 31.9 on pp. 1063–5 (Specific commitment)

37. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–37 Foreign currency swaps Commonly used swaps are: – interest rate swaps, e.g. where a fixed-interest-rate obligation is swapped for a variable-rate obligation (refer to Chapter 14) – foreign currency swaps—where the obligation related to a loan denominated in one currency is swapped for a loan denominated in another currency (continues)

38. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–38 Foreign currency swaps (cont.) Reasons for foreign currency swaps If an organisation has a number of receivables denominated in a foreign currency, to hedge against exchange fluctuations it may convert some domestic loans into foreign currency loans, in the same denomination as that of the receivables Need to find another entity that is prepared to swap its foreign currency loans for the organisation’s domestic currency loans

39. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–39 Contractual obligations of foreign currency swaps The other parties to the loans may not know about the swap arrangements Contractual relationship between entity and lending institution remains unchanged Should one party to the swap default on the arrangement, the obligation for repayment vests with the primary borrower Refer to Worked Example 31.10 on pp.1066–8— Example of a foreign currency swap

40. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–40 Summary The chapter deals with various issues associated with the translation of transactions that are denominated in a foreign currency To account for transactions in a foreign currency, three accounting standards need to be considered: 1. AASB 121 ‘The Effects of Changes in Foreign Currency Rates’ 2. AASB 123 ‘Borrowing Costs’ 3. AASB 139 ‘Financial Instruments: Recognition and Measurement’ (continues)

41. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–41 Summary (cont.) Key issues – Foreign currency transactions should initially be translated at the spot rate in place at the date of the transaction using the functional currency as the basis for the translation – The functional currency might be different from the presentation currency – Any changes in the Australian dollar equivalents of foreign currency monetary amounts (e.g. foreign currency receivables, foreign currency payables, and foreign currency monetary deposits) are, with limited exceptions, to be recognised as a gain or loss in the income statement, whether or not the gains have been realised (continues)

42. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–42 Summary (cont.) Any gains or losses on foreign currency receivables and payables are not to be offset against related purchases or sales amounts If the movement relates to a ‘qualifying asset’ AASB 123 requires the movement to be adjusted against the cost of the asset—foreign currency movements will be adjusted against the cost of the asset only as long asset’s adjusted book value does not exceed its recoverable amount Once an asset ceases to be a ‘qualifying asset’ all movements in related monetary terms are to go to the income statement (continues)

43. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–43 Summary (cont.) Where hedge contracts have been entered into, the forward-rate contracts and purchase or sales transactions must be accounted for separately Where hedge transactions satisfy the five conditions necessary for applying hedge accounting, AASB 139 requires any costs associated with entering a cash-flow hedge (per chapter) to be deferred to equity and subsequently included in the costs or sales price of the goods or services Any changes in the value of the forward-rate contract receivables or commitments are to be deferred in equity and subsequently included as part of the costs of the goods or services to the extent they occur up until the purchase or sale date (continues)

44. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan 31–44 Summary (cont.) If a hedge transaction is taken out subsequent to the purchase or sale date, any changes in the value of the hedge receivable or forward-rate contract commitment are to be transferred to the income statement Where hedges do not specifically relate to the future purchase or sale of goods or services, any costs associated with entering the hedge are to be amortised over the period of the hedge arrangement Foreign currency swaps may be undertaken as a form of hedging: – where a swap occurs the primary borrower will still have a commitment to the primary lender should the other party to the swap default on the swap arrangement It is not correct practice to eliminate a particular loan from the accounts when a swap arrangement has been negotiated