Accounting for Foreign Currency Transactions – Quick-Review Notes

Foreign Currency Transactions

• Occur when a company's transaction currency is different from its functional currency. (e.g., a Canadian firm using ext{C$} as functional currency, but buys inventory in ext{US$}).

Functional Currency Determination

• The currency of the primary economic environment in which the entity operates.

• Once determined, it should only be changed if the underlying economic facts change significantly.

• Any change in functional currency must be disclosed, including the nature and reason for the change.

Exchange-Rate Basics

• Direct quote: How much local currency is needed to buy one unit of foreign currency.

  • Example: ext{US ext{ }1} = ext{C} ext{ }1.4100 (meaning 1 US dollar costs 1.4100 Canadian dollars).

• Indirect quote: How much foreign currency can be bought with one unit of local currency.

  • Example: ext{C} ext{ }1 = ext{US} ext{ }0.7092 (meaning 1 Canadian dollar buys 0.7092 US dollars).

  • It is the reciprocal of the direct quote (1 / 1.4100 \approx 0.7092).

IAS 21 / ASPE 1651 – Three-Step Model for Foreign Currency Transactions

This model dictates how to account for transactions denominated in a foreign currency.

1. Determine Functional Currency: This is the first crucial step, as described above.

2. Initial Measurement: Record the transaction at the spot rate (the prevailing exchange rate) on the transaction date.

   • For items occurring evenly throughout a period (e.g., sales), an average rate for that period might be allowed as a practical expedient.

3. Subsequent Measurement: At each financial statement date, re-evaluate items based on their classification:

   • Monetary Items (e.g., cash, accounts receivable, accounts payable, loans):

     • These represent a fixed or determinable amount of currency to be received or paid.

     • Remeasure these at the closing (spot) rate on the financial statement date.

     • Any gain or loss from this re-measurement (due to exchange rate fluctuations) is recognized immediately in profit or loss (P&L).

   • Non-Monetary Items at Historical Cost (e.g., inventory, property, plant & equipment (PPE), intangibles, prepaid expenses, unearned revenue):

     • These items do not represent a fixed amount of currency.

     • They are kept at their original translated historical rate (the rate used on the transaction date).

     • No foreign exchange adjustment is made until the item is derecognized (sold or disposed of).

     • Depreciation or Cost of Goods Sold related to these items is also calculated based on their original translated ext{C$} value.

   • Non-Monetary Items at Fair Value (e.g., certain investments, revalued PPE):

     • These are translated using the exchange rate on the revaluation date (the date the fair value was determined).

     • The foreign exchange effect is embedded within the revaluation gain or loss and is recognized where the revaluation gain/loss itself is recognized (either P&L or Other Comprehensive Income (OCI)), depending on the applicable accounting standard for that asset.

Monetary Items (Detailed)

• Examples: Cash, accounts receivable (A/R), accounts payable (A/P), bank loans, bonds payable.

• Remeasurement: At each reporting period, remeasure these using the closing rate.

• FX Gain/Loss Calculation: ( ext{Closing Rate} - ext{Prior Period Rate}) \times \text{Foreign Currency Amount}.

• Recognition: The resulting gain or loss is recognized directly in profit or loss for the current period.

Non-Monetary Items (Detailed - Historical Cost)

• Examples: Inventory, property, plant, and equipment (PPE), intangible assets, prepaid expenses, unearned revenue.

• Treatment: These items remain at their original translated amount (the value at the initial transaction date).

• No FX Adjustment: No changes are made due to subsequent exchange rate fluctuations, because their value is tied to their historical cost, not a future cash flow in foreign currency.

Fair-Value Non-Monetary Items (Detailed)

• Process: First, revalue the asset to its fair value in the foreign currency. Then, translate this fair value into the functional currency using the exchange rate prevailing on the date the fair value was determined.

• Recognition of Revaluation/FX: The entire revaluation amount (which includes the FX component) follows the accounting treatment for that specific asset under its relevant standard.

  • For example, if a revaluation gain/loss on PPE goes to OCI under IAS 16, then the FX component embedded in it also goes to OCI.

Derecognition (Settlement)

• Monetary Items: When settled (e.g., a foreign currency receivable is collected), update the item to the spot rate on the settlement date just before removal. Any final gain/loss is recognized in P&L.

• Non-Monetary Items: When disposed of (e.g., inventory is sold, PPE is scrapped), they are removed at their carrying amount (which is either their historic cost or their latest fair value). There is no special foreign exchange adjustment step at derecognition for these items beyond what has already been accounted for.

Presentation & Disclosure (IAS 21)

• Disclose Functional Currency: Clearly state the functional currency used by the entity.

• Total FX Gain/Loss: Report the aggregate foreign exchange gain or loss in the Statement of Comprehensive Income (usually within profit or loss).

• Functional Currency Change: If the functional currency changes, disclose both the old and new currency, along with a clear rationale for the change.

IFRS vs ASPE Key Difference

• Non-Monetary Items at Fair Value:

  • IFRS: Requires using the exchange rate on the date the fair value was determined, which is often the reporting (balance sheet) date.

  • ASPE: Explicitly requires using the balance-sheet-date rate for these items.

• Other Alignments: Aside from this specific point for fair-valued non-monetary items, the guidance under IFRS and ASPE is largely consistent regarding:

  • Initial recognition at spot rate.

  • Distinction between monetary and non-monetary items.

  • Recognition of gains/losses in profit or loss.

Here are the answers to your learning outcomes, designed to help you understand and grasp the concepts:

1. Describe foreign currency transactions.

Foreign currency transactions occur when a company's business activities (like buying or selling) are in a currency different from its primary operating currency (known as its functional currency). For example, if a Canadian company primarily uses Canadian dollars ( ext{C$}) but buys goods from a supplier in the United States and agrees to pay in US dollars ( ext{US$}).

2. Describe initial measurement of foreign currency transactions.

When a foreign currency transaction first happens, it must be recorded in the company's functional currency. This is done by translating the foreign currency amount using the spot rate (the exchange rate at that exact moment) on the transaction date. If many similar transactions happen throughout a period (like continuous sales), it might be acceptable to use an average exchange rate for that period as a simplified approach.

3. Describe subsequent measurement of assets and liabilities denominated in a foreign currency.

At each financial statement reporting date, items related to foreign currency transactions must be re-evaluated based on their type:

• Monetary Items (e.g., cash, accounts receivable, accounts payable, loans):

  • These are assets or liabilities that represent a fixed or clearly determinable amount of currency to be received or paid in the future.

  • They are re-measured at the closing (spot) rate on the balance sheet date.

  • Any resulting exchange rate gain or loss due to currency fluctuations is recognized immediately in profit or loss (P&L) for that period.

• Non-Monetary Items at Historical Cost (e.g., inventory, property, plant & equipment (PPE), intangible assets, prepaid expenses, unearned revenue):

  • These items do not represent a fixed amount of currency to be received or paid. Their value is based on their original cost.

  • They are kept at their original translated historical rate (the rate used on the transaction date).

  • No foreign exchange adjustment is made for these items due to subsequent currency fluctuations as long as they are still on the balance sheet. Depreciation or Cost of Goods Sold related to these assets is also based on their original functional currency value.

• Non-Monetary Items at Fair Value (e.g., certain investments, revalued PPE):

  • These items are first revalued to their fair value in the foreign currency.

  • Then, this foreign currency fair value is translated into the functional currency using the exchange rate on the date the fair value was determined (which is often the reporting date).

  • The foreign exchange impact is included within the overall revaluation gain or loss. This combined gain or loss is recognized in the same place where the revaluation gain/loss itself would normally go (either P&L or Other Comprehensive Income (OCI)), depending on the accounting standard for that specific asset.

4. Describe derecognition of assets and liabilities denominated in a foreign currency.

Derecognition happens when an asset or liability is no longer on the company's books, for example, when a receivable is collected or inventory is sold.

• Monetary Items: When a monetary item (like a foreign currency receivable) is settled, its value needs to be updated to the spot rate on the settlement date just before it's removed from the books. Any final gain or loss from this last translation is recognized in profit or loss.

• Non-Monetary Items: When non-monetary items (like inventory or PPE) are disposed of, they are simply removed at their current carrying amount (which is either their historical cost or their latest fair value). There isn't an additional foreign exchange adjustment specifically at the point of derecognition for these items, beyond what was already accounted for in prior measurements.

5. Identify presentation and disclosure requirements for foreign currency transactions.

According to IAS 21 (and similar for ASPE 1651):

• The company must clearly state its functional currency in its financial statements.

• The total foreign exchange gain or loss for the period must be reported in the Statement of Comprehensive Income (typically within profit or loss).

• If there is a change in the company's functional currency, both the previous and new currency must be disclosed, along with a clear reason for the change.

6. Describe the difference between IFRS and ASPE in accounting for foreign currency transactions.

While IFRS (International Financial Reporting Standards) and ASPE (Accounting Standards for Private Enterprises) are largely similar in their approach to foreign currency transactions, there is one key difference related to Non-Monetary Items at Fair Value:

• IFRS: Requires these items to be translated using the exchange rate on the date the fair value was determined, which is often the reporting (balance sheet) date.

• ASPE: Explicitly requires using the balance-sheet-date rate for translating these items. This means ASPE is more specific about when the rate should be applied if fair value is determined at the reporting date.

Beyond this specific point, both standards agree on initial recognition at the spot rate, distinguishing between monetary and non-monetary items, and recognizing most foreign exchange gains/losses in profit or loss.