IFRS 9 Financial Instruments s1

for Accounting Professionals

IAS 21 The effects of changes in foreign exchange rates

2011

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IAS 21 The effects of changes in foreign exchange rates

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IAS 21 The effects of changes in foreign exchange rates

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The workbooks cover various concepts of IFRS based accounting. They are intended to be practical self-instruction aids that professional accountants can use to upgrade their knowledge, understanding and skills.

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TACIS project partners included Rosexpertiza (Russia), ACCA (UK), Agriconsulting (Italy), FBK (Russia), and European Savings Bank Group (Brussels). The help of Philip W. Smith (editor of the third edition) and Allan Gamborg, project managers and Ekaterina Nekrasova, Director of PricewaterhouseCoopers, who managed the production of the Russian version (2008-9) is gratefully acknowledged. Glyn R. Phillips, manager of the first two projects conceived the idea, designed the workbooks and edited the first two versions. We are proud to realise his vision.

Robin Joyce

Professor of the Chair of

International Banking and Finance

Financial University

under the Government of the Russian Federation

Visiting Professor of the Siberian Academy of Finance and Banking Moscow, Russia 2011 Updated

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IAS 21 The effects of changes in foreign exchange rates

IAS 21 The effects of changes in foreign exchange rates

Contents

1. Consolidation Introduction 3

2. Definitions 4

3. IAS 21 for Banks 5

4. Foreign Currency Transactions in the Normal Course of Business 6

5. Initial Recognition of a Transaction 7

6. Reporting at Balance Sheet Dates 8

7. Financial Statements of Foreign Operations 9

8. Disposal of a Foreign Operation 17

9. Disclosure Requirements 19

10. Annex – Examples -Foreign operations with non-coterminous year ends 19

11. Multiple Choice Questions 21

12. Exercise Questions 24

13. Solutions 28

14. IFRS Framework 30

Note: Material from the following PricewaterhouseCoopers publications has been used in this workbook:

Applying IFRS , IFRS News, Accounting Solutions

1. Consolidation Introduction

Aim

The aim of this workbook is to assist the individual in understanding consolidation methodology for IFRS and the role of foreign currency both in consolidated statements and single-undertaking financial statements. It also covers foreign currency transactions arising from trade.

Consolidation Approach

Before commencing a consolidation, the accountant should have the full financial statements of the parent and subsidiaries produced as of the same date, and having used the same accounting policies.

Where possible, all subsidiary year-ends must be the same as the parent undertaking. Under IAS 27, the maximum permitted difference is 3 months.

Adjustment should be made for any significant differences created by any subsidiary having a different accounting date.

The length of reporting periods and any difference in the reporting dates should be consistent from period to period.

Transactions between group undertakings should be listed, and balances between group undertakings should be agreed and listed.

Where an undertaking has been purchased, the financial statements at the time of acquisition should be on hand. Similarly, where an undertaking has been sold, the financial statements on the date of sale should be available.

Spreadsheets are ideal for producing consolidated balance sheets and income statements, although bespoke consolidated software is available.

OTHER COMPREHENSIVE INCOME

IAS 1 introduced Other Comprehensive Income as a financial statement.

All movements into and out of revaluation reserves and foreign currency translations (both in Equity) are recorded here.

If a gain, or loss, is reported in profit and loss, any related exchange gain, or loss, will also be reported in profit and loss.

If a gain, or loss, is reported in Other Comprehensive Income, any related exchange gain, or loss, will also be reported in Other Comprehensive Income.

2. Definitions

Undertaking

An undertaking is any business, either incorporated or unincorporated.

Parent

A parent is an undertaking that controls another undertaking.

Subsidiary

A subsidiary is an undertaking that is controlled by another.

Group, or business combination

Two or more companies where one company controls the other(s).

Dissimilar business activities must be consolidated, if they controlled by the parent undertaking.

Control

Control is the power to govern the financial and operating policies of an undertaking to obtain benefits.

Indications of control are:

q  Ownership of more than 50% of the voting rights.

Effective control over more than 50% of the voting rights. For example, a husband owns 30% and a wife owns 40%.
As they are connected parties, they can exercise control over the subsidiary.

q  Controlling the composition of the board of directors

Fair value

Fair value is the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. (IFRS 13)

Monetary items

Monetary items are money held, assets receivable, and liabilities payable, in cash.

Associate

An undertaking in which the parent has significant influence, but is neither its subsidiary, nor part of a joint venture of the parent.

Indications of significant influence are:

q  Ownership of 20-50% of the voting shares

q  Representation on the Board of Directors

Joint Venture

A joint venture is an undertaking subject to the joint control of two or more enterprises. The joint control is governed by a contract between the parties.

Foreign Operation

A foreign operation is a branch, associate, joint venture or subsidiary, where the activities are conducted in a different country to that of the parent undertaking.

Presentation Currency

The presentation currency is that used in the parent’s and in the consolidated financial statements.

FUNCTIONAL CURRENCY

The functional currency is the currency of the primary economic environment in which the undertaking operates.

Foreign Currency

Foreign currency is any currency other than the functional currency.

Exchange Difference

Exchange difference is the difference calculated from reporting the same number of units of a foreign currency at different exchange rates.

Closing Rate

The closing rate is the spot exchange rate at the balance sheet date.

Net Investment in a Foreign Undertaking

The net investment in a foreign operation is the parent’s share of the net assets of the undertaking.

Spot exchange rate

The Spot exchange rate is the exchange rate for immediate delivery.

3. IAS 21 for Banks

The majority of bank transactions in foreign currency relate to financial instruments. These are revalued daily in most countries, using the rates provided by the Central Bank, with revaluation differences going to the income statement.

This treatment is the same under IFRS (with the exception of available-for-sale financial instruments, where the revaluation difference will go to equity until they are sold).

Dealing in foreign currencies involves another layer of risk for Banks (Barings Bank in the UK was bankrupted by speculating on the Japanese Yen), but also for bank clients, who often are unable (or unwilling) to fully manage their foreign currency risk.

IFRS 7 requires banks to detail exposure and the management of their foreign exchange risk in financial statements.

IFRS 9 applies to many foreign currency derivatives and, accordingly, these are excluded from the scope of IAS 21.

However, those foreign currency derivatives that are not within the scope of IFRS 9 (for example) some foreign currency derivatives that are embedded in other contracts) are within the scope of IAS 21.

In addition, IAS 21 applies when an entity translates amounts relating to derivatives from its functional currency to its presentation currency.

4. Foreign Currency Transactions in the Normal Course of Business

Transactions and Investments in Foreign Currencies

Transactions and investments in foreign currencies increase business risk due to the currency fluctuations against the national currency.

Holding any assets, or liabilities, denominated in foreign currency entails a currency risk. There is a risk that you will make a profit or loss, if the exchange rate changes when settlement is made. Techniques such as hedging, forward contracts and options may be employed to reduce risk.

International business necessitates many firms trading in foreign currencies. The time between quoting a price fixed in a foreign currency, and finally receiving the funds should be minimised to limit risk.

Example:

You quote a price of $1000 for an item. Based on today’s exchange rate, you will make a profit of 25%. However, the Rouble strengthens against the $ by 10% per month, eliminating your profit before you receive the cash in month 5:

While this illustration is extreme, the risk is always present.

Investments, such as a foreign branch or subsidiary, increase the time that the parent is at risk to currency fluctuations.

The foreign operation may trade profitably, but the investment may be adversely hit by a fall in the foreign currency against that of the parent.

Commission costs, incurred in buying or selling foreign currencies, reduce profits. Exchange controls may inhibit the parent from repatriating funds to reduce risk.

A firm needs to know its foreign exchange exposure, from transactions and investments. It needs to develop and refine a strategy to handle fluctuations in each currency to which it is exposed.

When a gain, or loss, on exchange is realised by settling a foreign currency item, nothing more can be done, except to update the books of account.

Only a review of the unrealised gains and losses provides opportunities for performance improvement.

5. Initial Recognition of a Transaction

If a company transacts business, or holds assets or liabilities in a foreign currency, the transaction should be accounted for at the exchange rate on the day of the transaction. The rate that should be used is the mid-market rate ‘spot’ rate on the day the transaction takes place.

An average rate may be used for a week, or a month, for all transactions in each foreign currency, if there is no material fluctuation in the exchange rates.

The date of the transaction is the date when the transaction is contracted, or recognised, rather than the date of receiving (or paying) cash. If the receipt of cash is earlier, a payment in advance is registered. If later, an account receivable, or payable, would be recognised at the spot rate.

Example:

On 1st January, you sell $100 of services to a foreign customer on credit. The exchange rate is $1=30 Roubles.

In the Russian books of account, you:

Debit Accounts Receivable 3000

Credit Sales 3000

The cash is received in $ on February 1st when the exchange rate is $1 = 25 Roubles. The Rouble is stronger and the dollar weaker compared to the rate on January 1st.

In the Russian books of account, you:

Debit Cash 2500

Debit Exchange Loss 500

Credit Accounts Receivable 3000

In this case, less Roubles (500) are received than would have been the case had the $100 been received on 1st January.

If the dollar had strengthened against the Rouble, by February 1st, more Roubles would have been received in exchange for the $100. For example if the rate had been $1=40 Roubles, this would have created an exchange gain of 1000 Roubles.

Gain or Loss?

If you keep your books in Roubles, but trade is denominated in $, movements in the $ against the Rouble will have the following results from your $ denominated assets and liabilities:

6. Reporting at Balance Sheet Dates

Monetary items (money held, assets receivable, and liabilities payable, in cash or cash equivalents) will be reported at the closing rate (mid-market rate on the balance sheet date).

Non-monetary items (such as property, plant and equipment) should be reported at the exchange rate of the transaction.

This will either be the exchange rate of historic cost, or the valuation date, where fair values are used.

Example:

Equipment was bought from abroad on Jan 1st, but had not been paid for by March 31st, when the period ended.

The exchange rates were:

January 1st $1=30 Roubles.

March 31st $1=24 Roubles.

The cost of the equipment was $2000, and depreciation for the period was 5% of cost.

In the Russian books of account, the following balances would appear:

Equipment cost 60000

Depreciation 3000

Net book value 57000

Accounts payable 48000

Exchange gain 12000 (re accounts payable)

Notes: Cost = 2000*30= 60000

Depreciation= 5% (60000)= 3000