ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)
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Chapter 8: Foreign currency
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Example
A UK company borrowed US$900,000 on 3 June when the spot rate was $1.80 = £1.
At 31 December the exchange rate was $1.90 = £1. An interest payment of $18,500
was made on 3 December when the spot exchange rate was $1.85. The loan is a
monetary item, denominated in US dollars.
The loan is recognised initially as £500,000 ($900,000/1.80).
On 31 December, the loan is re-translated as £494,949 ($900,000/1.90). There is an
exchange difference on retranslation of £5,151 (£500,000 – £494,949). As the
liability has fallen in value, this represents an exchange gain. The loan is a
monetary item; therefore the gain will be reported in profit or loss for the year.
The interest payment of $18,500 is recognised at £10,000 ($18,500/1.85). This item
is translated at the spot rate on the date of the transaction.
Example
A UK company bought a machine from a German supplier for €260,000 on 1 March
when the exchange rate was €1.30 = £1. By 31 December, the end of the company’s
accounting year, the exchange rate was €1.20 = £1.
At 31 December, the UK company had not yet paid the German supplier any of the
money that it owed for the machine.
At the year end
The machine is recognised initially at £200,000 (€260,000/1.30). As it is a non-
monetary item, it will not be re-translated and there is no gain or loss.
However, the company purchased the machine on credit and had not settled the
account payable by the year-end. The amount payable should be re-translated at the
closing rate, because this is a monetary item. The payable would therefore be re-
translated to £216,667 (= €260,000/1.20).
The re-translation will give rise to an exchange difference. In this example the re-
translated amount of the liability is higher, and a loss of $16,667 should be reported
in profit or loss for the year.
2.4 Reporting at the settlement of a transaction
The settlement of a foreign currency transaction involves a receipt or payment in
foreign currency. Settlement in the foreign currency is made at the spot exchange
rate that applies on that date. (Note: This chapter ignores the possibility of using a
forward exchange contract to fix the exchange rate in advance: the accounting
effects of forward contracts are explained in another chapter.)
The exchange rate at the settlement date may be:
different from the spot rate on the date of the original transaction, and
different from the closing exchange rate at the end of the previous reporting
period (if there is a year-end between the original transaction and settlement).
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A gain or loss on translation may therefore occur:
at the end of a reporting period and in addition
at settlement of the transaction.
For example, suppose that a UK company buys goods, payable in US dollars, from a
US supplier on 10 December Year 1. Its year end is 31 December, and the company
pays the supplier on 9 February Year 2.
In this situation:
The purchase transaction will be recorded in sterling at the spot rate on 10
December Year 1.
The trade payable will also be recorded in sterling at the spot rate on 10
December Year 1.
The trade payable will be re-translated on 31 December at the year-end, because
it is a monetary item. A gain or loss will arise on the re-translation, and this will
be recognised in profit or loss for the year ending 31 December Year 1.
The US supplier is paid on 9 February, and the cost of obtaining the dollars to
make the payment will be the exchange rate available on 9 February, the
settlement date.
If the cost of the settlement is different from the amount at which the transaction is
recorded in the ledger accounts (the amount at which the payable was re-translated
on 31 December Year 1), a further gain or loss will arise. This is the difference
between the translated value of the liability in the ledger accounts and the actual
cost of making the settlement. This settlement gain or loss should be included in
profit or loss for the year ended 31 December Year 2.
Example
A UK company sells goods to a customer in Saudi Arabia for $72,000 on 12
September, when the exchange rate was $1.80 = £1. It received payment on 19
November, when the exchange rate was $2 = £1. The financial year-end is 31
December.
The sale will be initially translated at the spot rate. This will give rise to revenue
and receivables of £40,000 ($72,000/1.80).
The receipt of the payment is recorded at £36,000 ($72,000/2.00).
The receivable has fallen in value over the two months: it was initially recorded
at £40,000 but at settlement it is only worth £36,000. The company has an
exchange loss on settlement of £4,000. This is recognised in profit or loss for the
year.
Chapter 8: Foreign currency
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Example
A UK company buys goods from a US supplier for $30,000 on 30 November Year 1
when the spot exchange rate was $1.50. The company has a financial year that ends
on 31 December. At 31 December Year 1, the exchange rate is $1.80 = £1. The
payment for the goods is made on 16 March Year 2, when the exchange rate was
$1.60 = £1.
The transaction is recorded initially at £20,000 ($30,000/1.50).
Debit Purchases £20,000
Credit: Trade payables £20,000.
If the purchased inventory is still held at the end of the reporting period on 31
December Year 1, it is not re-translated because inventory is a non-monetary
item.
However, the amount payable at 31 December Year 1 is re-translated to the
closing rate, giving a revised balance of £16,667 ($30,000/1.80).
The re-translated amount of the liability is lower; so there is a gain on the re-
translation of £3,333. This gain is included in profit or loss for Year 1.
Debit: Trade payables £3,333
Credit: Profit or loss £3,333.
The payment on 16 March Year 2 is recorded at the exchange rate on settlement
date. The payment is therefore £18,750 ($30,000/1.60).
Debit: Trade payables £16,667
Credit: Cash £18,750
There is a loss on settlement of £2,083 (£18,750 – £16,667), arising from the
exchange difference between translating the foreign currency amount at the end
of the previous reporting period and at the settlement date. This gain or loss
from the exchange difference is included in profit or loss for Year 2.
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The foreign operation: accounting rules
Three stages in the consolidation process
The translation stage
The consolidation stage
Consolidation example
3 The foreign operation: accounting rules
3.1 Three stages in the consolidation process
If a company has a foreign operation (such as a foreign subsidiary) that prepares its
accounts in a functional currency that is different from the group’s presentation
currency, there are three stages in the accounting process, for the purpose of
preparing consolidated financial statements (or including the foreign associate or
joint venture in the financial statements of the reporting entity).
Stage Description
Adjust and update
Ensure that the individual financial statements of the
foreign entity is correct and up-to-date.
If any adjustments are required to correct the financial
statements of th eforeign entity, these should be made
in the statements of the foreign entity and in its own
functional currency.
Translate
The assets and liabilities of the foreign entity should be
translated into the presentation currency of the parent
company. (As explained earlier, the presentation
currency of the parent company might be the same or
might be different from its functional currency.)
The rules for translation are explained below.
Consolidate
After translation, all the financial statements are now
in the same currency.
Normal group accounting principles are now used to
prepare the consolidated accounts of the group.
3.2 The translation stage
The rules set out below apply where the functional currency of the foreign entity is
not a currency suffering from hyperinflation. (Hyperinflation is where the country’s
rate of inflation is very high. When there is hyperinflation, IAS 29 provides special
accounting rules, which are described later.)
Chapter 8: Foreign currency
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The normal rules for translation, contained in IAS 21, are as follows:
(1) The statement of financial position
The assets and liabilities of the foreign operation, for inclusion in the
consolidated statement of financial position, are translated at the closing
rate. (Comparative figures for the previous year are translated at the same
rate.)
For foreign subsidiaries, this rule also applies to purchased goodwill
arising on the acquisition of the subsidiary.
(2) The statement of comprehensive income or income statement
Income and expenses for inclusion in the consolidated statement of
comprehensive income or consolidated income statement are translated at
the spot rates at the dates of each of the transactions.
For practical reasons, average rates for a period may be used, if they
provide a reasonable approximation of the spot rates when the
transactions took place.
(3) Exchange differences
All resulting exchange differences are recognised in other comprehensive
income for the period and are credited (gain) or debited (loss) to a separate
reserve within the equity section of the consolidated statement of financial
position, and this reserve is maintained within equity until the foreign
operation is eventually disposed of.
Gains or losses are therefore reported as gains or losses in other
comprehensive income and movements in the separate reserve, and not as
a gain or loss in profit or loss and an increase or reduction in retained
earnings.
The gain or loss on translation
The exchange differences on translation (see (3) above) result in a gain or loss. These
gains or losses arise from a combination of two factors:
Income and expense items are translated at the exchange rates ruling during the
period, but assets and liabilities are translated at closing rates. The profit is
therefore calculated at the actual exchange rates, but the accumulated profit in
the consolidated statement of financial position is re-translated at the closing
rate.
The net assets of the subsidiary were translated at last year’s closing rate at the
end of the previous financial year. These net assets have now been retranslated
and included in this year’s statement of financial position at this year’s closing
rate.
IAS 21 states that these differences on translation are not recognised in profit or loss
because changes in the exchange rates for these items have little or no effect on cash
flows from operations. It would therefore be misleading to include them in profit or
loss.
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Example
A UK parent company has a US subsidiary, which is 100% owned. The following
information is available about the subsidiary for the year to 31 December Year 5:
Openingnetassets,1January $20,000
Profitfortheyear $10,000
Closingnetassets,31December $30,000
Dividendspaid $0
Relevant $/£ exchange rates are as follows:
1JanuaryYear5 $1.70=£1
Averagefortheyear $1.80=£1
31DecemberYear5 $1.90=£1
Required
Calculate the total gain or loss on translation for the year, analysing it between:
the gain or loss on re-translating income and expenses
the gain or loss on re-translating the opening net assets.
Answer
The entire profit for the year is included in accumulated profit at the end of the year,
because no dividends were paid during the year.
Exchangedifference:gainor(loss)
Onre‐translatingtheopeningnetassets:
£ £
$20,000atopeningrate1.70 11,765
$20,000atclosingrate1.90
10,526
––––––––––––––––
(1,239)
Onre‐translatingtheprofitfortheyear:
$10,000ataveragerate1.80
5,556
$10,000atclosingrate1.90
5,263
–––––––––––––––––
(293)
––––––––––––––––
Exchangelossarising
(1,532)
––––––––––––––––
The exchange loss should be recognised in other comprehensive income for the year
and taken to a separate reserve within equity in the consolidated statement of
financial position.
Chapter 8: Foreign currency
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3.3 The consolidation stage
After the translation stage, the financial statements of the overseas entity are in the
presentation currency of the parent company.
The basic rule is that normal consolidation techniques can now be used. However, a
foreign exchange reserve must be included in the consolidated statement of
financial position for the cumulative exchange differences.
It is also necessary to comply with the requirements of IAS 21 for purchased
goodwill and foreign subsidiaries.
Purchased goodwill and foreign subsidiaries
IAS 21 requires that goodwill and any fair value adjustments arising on the
acquisition of a foreign subsidiary are to be treated as part of the assets and
liabilities of the foreign subsidiary. The rules already described apply to these items.
This means that:
Goodwill arising on the purchase of the foreign subsidiary (and also any fair
value adjustments to the value of assets of the subsidiary) should be stated in the
functional currency of the foreign subsidiary.
The goodwill and fair value adjustments will therefore be translated each year at
the closing exchange rate.
A gain or loss on translation will therefore arise (as described above for other assets
and liabilities).
The effect of this rule is that goodwill and the acquisition of a foreign operation is
re-stated over time because it is re-translated every year at the new closing exchange
rate.
The rationale behind this accounting rule is that the amount paid for the investment
in the subsidiary has been based on the expected future earnings stream. The
goodwill relates to a business which operates in the economic environment of
another country and should therefore be expressed in the functional currency of the
foreign subsidiary.
Example
A UK holding company acquired 100% of the capital of a US subsidiary on 30
September Year 6 at a cost of $8 million. The fair value of the net assets of the
subsidiary at that date was $3 million.
The holding company prepares financial statements at 31 December each year. The
company uses the partial goodwill method to account for non-controlling interests,
and no goodwill is attributed to NCI.
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Relevant $/£ exchange rates are as follows:
30 September Year 6 $2.00 = £1
31 December Year 6 $1.90 = £1
Required
(a) Calculate the goodwill arising at the date of the acquisition, in £.
(b) Calculate the goodwill (in £) which will appear in the consolidated statement
of financial position as at 31 December Year 6.
Answer
(a) Goodwill arising on acquisition
All elements of the calculation are initially translated at the spot rate of 2.00
$ Rate £
Costofinvestment
8m 2.00 4.0m
Minus:Netassetsacquired 3m 2.00 1.5m
Goodwill
5m 2.00 2.5m
(b) Goodwill at 31 December Year 6
The goodwill must be re-translated to the closing rate of 1.90 The goodwill is
therefore re-valued to £2.632 million (= $5m / 1.90).
An exchange gain of £0.132m (2.632m – 2.5m) has arisen on re-translation.
This exchange gain is recognised in other comprehensive income and
credited to the foreign exchange reserve within equity in the consolidated
statement of financial position.
3.4 Consolidation example
The following example looks at the whole process of foreign currency consolidation,
beginning with the translation of the foreign subsidiary’s accounts and finishing
with their consolidation into the parent group accounts.
Example
AB owns 75% of JK which is located in a different country. The currency of this
country is the Florin (Fl). AB acquired its shares in JK on 1 May Year 6 for 240
million Florins when the retained earnings of JK were 160 million Florins. Their
statements of financial position are shown below:
Chapter 8: Foreign currency
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Statementsoffinancialpositionat30AprilYear7:
AB
JK
$m
Flm
Tangiblenon‐currentassets 594 292
InvestmentinJK
48 ‐
Currentassets
768 204
1,410 496
Sharecapital 120 64
Sharepremium
100 40
Retainedearnings
720 190
940 294
Non‐currentliabilties 60 82
Currentliabilities
410 120
1,410 496
Notes:
(i) The fair value of JK’s net assets at acquisition is the same as their carrying
value.
(ii) JK operates with autonomy in its business operations.
(iii) AB uses the partial goodwill method to account for non-controlling
interests, and NCI does not include an amount for goodwill.
(iv) The following exchange rates are relevant:
1MayYear6
Fl5.0=$1
Averagefortheyear
Fl4.0=$1
30AprilYear7
Fl4.2=$1
Prepare a consolidated statement of financial position at 30 April Year 7
Answer
There are a number of steps that need to be followed in consolidating a foreign
currency operation.
Step 1
Deal with any adjustments to the accounts of the subsidiary and parent, e.g. inter-
company trading transactions and inter-company loans. Apply the normal rules for
dealing with these.
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Step 2
When the financial statements of the subsidiary have been updated and adjusted as
necessary, translate the subsidiary’s accounts into the reporting currency (in this
example translate from Florins into $).
Step 3
Calculate goodwill, consolidated reserves and non-controlling interest (the usual
rules for preparing a consolidated statement of financial position apply).
Step 4
Consolidate the parent with the translated accounts of the subsidiary.
Answer
There are no adjustments to make in Step 1 so we can go straight to the translation
in Step 2.
Step 2
The subsidiary’s statement of financial position is translated at the closing rate.
JKStatementoffinancialposition
Florins
(m)
Exchange
rate
$m
Noncurrentassets
Tangibleassets 292 4.2 69.5
Currentassets
204 4.2 48.5
496
118.0
Sharecapital 64 4.2 15.2
Sharepremium 40 4.2 9.5
Retainedearningsatacquisition
160 4.2 38.1
Netassetsatacquisition
264
62.8
Reserves–postacquisition 30 4.2 7.1
294
69.9
Non‐currentliabilties 82 4.2 19.5
Currentliabilities
120 4.2 28.6
496
118.0