ACCA P2 (INT) Corporate Reporting - Study text

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Chapter 7: Group reorganisations and restructuring

Benefits from the revised structure

The benefits are mainly strategic in nature:

 The revised/enlarged group has wider geographical coverage within the context

of a growing European Community.

 Growth by acquisition is quicker than organic growth.

 The growth is financed by a share issue with no immediate cash requirement.

 The effects of economies of scale and ‘synergy’ may result in more efficient

operations and increased profits.

 The formation of C and P into a sub-group will make any future sale or de-

merger easier to effect.

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Paper P2 (INT)

Corporate Reporting

CHAPTER

Foreign currency

Contents

1 IAS 21 The effects of changes in foreign exchange rates

2 The individual entity: accounting rules

3 The foreign operation: accounting rules

4 IAS 29 Hyperinflation

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IAS 21: The effects of changes in foreign exchange rates

 The scope of IAS 21

 The two main accounting issues

 Terms and definitions used in IAS 21: currency definitions

 Terms and definitions used in IAS 21: other definitions

1 IAS 21: The effects of changes in foreign exchange

rates

1.1 The scope of IAS 21

Many businesses have transactions and investments that are denominated in a

foreign currency.

 Individual companies often enter into transactions in a foreign currency. These

transactions need to be translated into the company’s own currency in order to

record them in its ledger accounts. For example:

− a US company may take out a loan from a French bank in euros and will

record the loan in its ledger accounts in US dollars

− a German company may sell goods to a Japanese company invoiced in yen

and will record the sale and the trade receivable in euros in its ledger

accounts.

 Groups often contain overseas entities. A parent company might own a foreign

subsidiary or associate. This foreign entity will normally maintain its accounting

records and prepare its financial statements in a currency that is different from

the currency of the parent company and the group’s consolidated accounts.

− For example, if a Japanese company has a US subsidiary, the financial

statements of the US subsidiary will be prepared in US dollars, but will need

to be translated into yen for the purpose of preparing the group’s

consolidated financial statements.

The rules on accounting for foreign currency items are concerned with translating or

converting items from one currency into another currency, at an appropriate rate of

exchange between the currencies. The rules are mostly contained in IAS 21 The

effects of changes in foreign exchange rates. The rules in IAS 21 can be divided into two

areas:

 Transactions affecting individual entities. IAS 21 deals with the translation of

these transactions when they occur and at subsequent dates when re-translation

at a different exchange rate may be necessary.

 Foreign operations (subsidiaries, associates etc) which affect the consolidated

financial statements. The rules in IAS 21 explain how to translate the financial

statements of the foreign subsidiaries, associates or joint ventures. Once

translated, the normal consolidation rules or equity accounting rules will apply.

Chapter 8: Foreign currency

One area that IAS 21 does not deal with is the translation of any transactions and

balances that fall within the scope of IAS 39 on financial instruments. For example, if

a company takes out a forward foreign exchange contract to hedge against foreign

currency exposure, the accounting treatment is covered by the rules in IAS 39,

because a forward contract is a financial instrument.

1.2 The two main accounting issues

Transactions and assets and liabilities in foreign currencies are translated or

converted from the foreign currency into the currency of the reporting entity. The

process of translation would be quite simple if exchange rates between currencies

remained fixed. However, exchange rates are continually changing. The translated

valuation of foreign currency assets or liabilities in the statement of financial

position might therefore change if they are translated at different times.

The two main accounting issues when accounting for foreign currency items are:

 What exchange rate(s) should be used for translation?

 How to account for the gains or losses that arise when exchange rates change?

Before looking at these accounting rules in detail, it is important to understand the

precise meaning of some key terms used in IAS 21.

1.3 Terms and definitions used in IAS 21: currency definitions

IAS 21 identifies three types of currency: the presentation currency, the functional

currency and foreign currency.

Currency Definition

Presentation currency

The currency in which the financial statements of an

entity are presented

Functional currency

The currency of the primary economic environment in

which an entity operates.

Foreign currency

A currency other than the functional currency of the

entity

Presentation currency

An entity is permitted to present its financial statements in any currency. This

reporting currency is often the same as the functional currency, but does not have to

be.

Functional currency

When a reporting entity prepares its financial statements, it must identify its

functional currency and prepare its financial statements in that currency. This rule

applies to stand-alone entities, parent companies and foreign operations (such as a

foreign subsidiary or a branch). When financial statements prepared in a functional

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currency are translated into a different reporting currency, the translation of assets

and liabilities must comply with the rules in IAS 21.

IAS 21 describes the functional currency as:

 The currency that mainly influences:

− sales prices for goods and services

− labour, material and other costs of providing goods or services.

 The currency in which funds are generated by issuing debt and equity

 The currency in which receipts from operating activities are usually retained.

The functional currency is not necessarily the currency of the country in which the

entity operates or is based, as the next example shows.



Example

P is a UK-registered mining company whose shares are traded on the London Stock

Exchange. Its operating activities take place in the gold and diamond mines of South

Africa.

(a) What is the presentation currency of P?

(b) What is its functional currency?

What type of currency is the US dollar, using the IAS 21 definitions?



Answer

(a) The reporting currency (presentation currency) is sterling (UK pounds). This

is a requirement of the UK financial markets regulator for UK listed

companies.

(b) The functional currency is likely to be South African rands, even though the

company is based in the UK. This is because its operating activities take place

in South Africa and so the company will be economically dependent on the

rand if the salaries of most of its employees, and most operating expenses and

sales are in rands.

accounts.

IAS 21 requires P to prepare its financial statements in its functional currency

(rands).

However, P is permitted to use sterling as its presentation currency. If it does use

sterling as its presentation currency (which it will do, given the UK rules), the

translation of assets and liabilities from rands to sterling must comply with the rules

in IAS 21.

Chapter 8: Foreign currency

1.4 Terms and definitions used in IAS 21: other definitions

Exchange rate definitions

IAS 21 uses the following terms to describe which exchange rate should be used in

the translation.

Term Definition

Exchange rate The rate of exchange between two currencies

Spot rate The exchange rate at the date of the transaction

Closing rate The spot exchange rate at the end of the reporting period

For example, suppose that on 16 November a German company buys goods from a

US supplier, and the goods are priced in US dollars. The financial year of the

company ends on 31 December, and at this date the goods have not yet been paid

for.

 The spot rate is the euro/dollar exchange rate on 16 November, when the

transaction occurred.

 The closing rate is the exchange rate at 31 December.

Other definitions

IAS 21 also includes some other terms and definitions.

Term Definition

Foreign operation This is a subsidiary, associate, joint venture or branch

whose activities are conducted in a country or currency

different from the functional currency of the reporting

entity.

Net investment in a

foreign operation

The amount of the reporting entity's interest in the net

assets of a foreign operation.

Exchange difference A difference resulting from translating the same assets,

liabilities, income or expenses from one currency into

another currency at different exchange rates. For example,

if net assets of £200,000 are translated into US dollars, first

at a rate of $1.75 = £1 and subsequently at a rate of $1.90 =

£1, the exchange difference is the difference between the

valuation at the two different rates.

Monetary items Units of currency held, or assets and liabilities to be

received or paid (in cash), in a fixed number of currency

units. Examples of monetary items include cash itself,

loans, trade payables, trade receivables and interest

payable.

Non-monetary items are not defined by IAS 21, but they are items that are not

monetary items. They include tangible non-current assets, investments in other

companies, investment properties and deferred taxation (which is a notional

amount of tax rather than an actual amount of tax payable.)

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The individual entity: accounting rules

 Initial recognition: translation of transactions

 Reporting at the end of each reporting period

 Gain or loss arising on translation

 Reporting at the settlement of a transaction

2 The individual entity: accounting rules

An individual company may have transactions that are denominated in a foreign

currency. These must be translated into the company’s functional currency for the

purpose of recording the transactions in its ledger accounts and preparing its

financial statements.

These transactions may have to be translated on several occasions. When a

transaction or asset or liability is translated on more than one occasion, it is:

 translated at the time that it is originally recognised, and

 re-translated at each subsequent occasion.

Re-translation may be required, after the transaction has been recognised initially:

 at the end of a financial year (end of a reporting period)

 when the transaction is settled, which may be either before or after the end of the

financial year.

On each subsequent re-translation, an exchange difference will occur. This gives rise

to a gain or loss on translation from the exchange difference.

2.1 Initial recognition: translation of transactions

On initial recognition, a transaction in a foreign currency must be translated at the

spot rate on the date of the transaction.

If the company purchases goods on most days in the foreign currency, it might be

administratively difficult to record every transaction at the actual spot rate. For

practical reasons, IAS 21 therefore allows entities to use an average rate for a time

period, provided that the exchange rate does not fluctuate significantly over the

period. For example, an entity might use an average exchange rate for a week or a

month for translating all the foreign currency-denominated transactions in that time

period.

These rules apply when an entity:

 buys goods or services that will be paid for in another currency

 sells goods or services invoiced in another currency

 borrows or lends when the interest payments and repayments of principal are in

another currency

Chapter 8: Foreign currency

 purchases or disposes of non-current assets in another currency, or

 receives dividends and other payments in another currency.



Example

A UK company has a financial year ending on 31 December. It buys goods from a

supplier in France on 17 November 20X6 invoiced in euros €140,000. The French

supplier is eventually paid in March 20X7.

Exchange rates over the period were as follows:

 17 November 20X1 €1 = £0.70

 31 December 20X1 €1 = £0.75

 Average for November €1 = £0.72

The purchase/inventory and the trade payable should be recorded initially by

translating the transaction at the spot rate of €1 = £0.70. This gives a translated value

of £98,000 for recording in the ledger accounts (€140,000 × 0.70).

For practical purposes, if the entity buys items in euros frequently, it may be able to

use an average spot rate for a period, for all transactions during that period.

2.2 Reporting at the end of each reporting period

Transactions in a foreign currency

Transactions in a foreign currency may still ‘exist’ in the statement of financial

position at the end of the financial period. They were recognised initially in the

accounts at the spot rate on the date of the transaction. However exchange rates

change over time and the exchange rate at the end of the reporting period will not

be the same as the spot rate on the date of the transaction.

For example, there may be a trade receivable in the statement of financial position

relating to a sale denominated in a foreign currency. The trade receivable would

have been translated at the spot exchange rate on the transaction date. It is still a

receivable in a foreign currency at the end of the reporting period.

An important accounting question is therefore: Should a different exchange rate

now be used now to translate the asset into the functional currency of the entity, for

the purpose of preparing the financial statements for the year?

Revaluations of non-current assets

A non-current asset in a foreign currency might be re-valued during a financial

period. For example, a UK company might own an office property in the US. The

cost of the office would have been translated at the spot rate when the property was

originally purchased. However, it might subsequently be re-valued. The revaluation

will almost certainly be in US dollars, and this re-valued amount will have to be

translated into the functional currency of the entity (in this example, sterling).

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 What exchange rate should be used to record the revaluation?

 What exchange rate should be used at the end of the reporting period, and at the

end of any subsequent reporting period?

The rules

The rules in IAS 21 for reporting assets and liabilities at the end of a subsequent

reporting period make a distinction between:

 monetary items, such as trade payables and trade receivables, and

 non-monetary items, such as non-current assets and inventory.

The rules are as follows, for entities preparing their individual financial statements:

Asset or liability Accounting treatment for the statement of

financial position:

Monetary items Re-translate at the closing rate.

Non-monetary items carried at

cost

No re-translation. The transaction is left at the

original spot rate.

Non-monetary items carried at

fair value

Re-translate at the exchange rate ruling at the

date of the fair value adjustment.

2.3 Gain or loss arising on translation

Any subsequent re-translation after the initial recognition of a transaction will give

rise to an exchange gain or loss if the exchange rate has changed since the initial

transaction date.

The gain or loss is the difference between the original and re-translated value of the

item.

 There is an exchange gain when an asset increases in value on re-translation, or

when a liability falls in value.

 There is an exchange loss when an asset falls in value on re-translation, or when

a liability increases in value.

A gain or loss arising on the re-translation of a monetary item should be

recognised in profit or loss in the period that it arises.

When a gain or loss on a non-monetary item is recognised in other comprehensive

income, any exchange rate gain or loss relating to it should also be included in other

comprehensive income. For example when a gain or loss on revaluation of a non-

current asset is reported as a gain in other comprehensive income, the related

exchange difference is also recognised in other comprehensive income rather than in

profit or loss for the period.

ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)

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